How Costly is a Misspecified Credit Channel DSGE Model in Monetary Policymaking?

In general, misspecified models can cause harm through suggesting policies that would in reality lead to destabilization of the economy as well as through limiting policy options and thus preventing the policymaker from achieving the first-best outcome. This paper specifically examines whether the choice of credit market frictions in new-Keynesian DSGE models matters in the context of monetary policymaking. We conduct a simulation exercise in which a financial crisis occurs and the monetary policymaker shifts its policy to combat the crisis. In choosing the new policy, the policymaker uses a credit channel model that suffers from a misspecification in the type of credit market friction. We find that the policymaker would choose a policy that not only destabilizes the economy but also performs considerably worse relative to an alternative policy that would have been chosen under a correctly specified model. We further demonstrate that allowing the use of public financial intermediation as a policy option plays a key role in the above result. Finally, we show that using a more flexible policy rule specification or reassigning stabilization objectives can mitigate the problem of model misspecification with varying success.