The Diagnostic Financial Accelerator

IMF Working Papers, June 28, 2024

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The paper develops a model combining Diagnostic Expectations (DE) and a Financial Accelerator (FA).
DE and FA generate mutually reinforcing shock amplification, with particularly strong amplification for demand shocks.
Supply shocks can be dampened via a debt deflation channel; this channel is strengthened in the presence of DE.
The model produces a worsening of the inflation-output volatility trade-off facing policymakers.

Diagnostic expectations amplify the financial accelerator mechanism, increasing the magnitude of macroeconomic responses to shocks.
Demand shocks experience especially pronounced amplification due to the interaction of DE and FA.
Supply shocks can be mitigated through a debt deflation channel; this mitigation is stronger when DE is present.
The inflation-output volatility trade-off deteriorates in the model, implying tougher stabilization choices for policymakers.
Contrary to much of the literature that argues against targeting the level of asset prices, this model suggests that targeting house price growth may yield welfare gains.

Policymakers face a worsened inflation-output volatility trade-off when DE is active alongside FA; stabilization strategies should account for this aggravated trade-off.
Consideration of house price growth as a policy target could produce welfare improvements in the context of the model with DE and FA.
Monetary policy rules and instrument design should account for model dynamics where asset-price growth interacts with financial amplification and expectations.

Subjects: Asset prices, Business cycles, Consumption, Economic growth, Housing prices, Inflation, National accounts, Prices
Keywords: Asset prices, Business cycles, Consumption, debt deflation channel, Diagnostic Expectations, Financial Accelerator, Global, house price growth, Housing prices, Inflation, inflation trade-off, inflation-output volatility trade-off, Instrument rules, model dynamics, Optimal monetary policy

IMF Working Paper No. 2024/132 — "The Diagnostic Financial Accelerator", Lahcen Bounader and Selim A Elekdag, June 28, 2024.