Monetary Stabilization in a Structurally Unstable Financial Environment

This paper analyzes monetary stabilization in a structurally unstable economy. The economy has multiple stationary states, differing in credit market conditions and economic activity. Under certain conditions two monetary stationary states are stable and self—fulfilling deflationary crises can occur. The model implies that adjusting long— run monetary conditions is insufficient to coordinate the inflation expectations of agents. To invalidate deflationary expectations a monetary impulse must overshoot the saddle—path to the high activity stationary state and be complemented by a long—run inflation target. The target can credibly be set subject to maintaining long—run price stability.