Overaccumulation, Interest, and Prices
An emerging view of business cycles from the news-shock literature suggests that recessions may occur when agents depress their demand for new capital upon the realization that they have accumulated too much conditional on current information. In this paper I use a New Keynesian model with a financial accelerator to study the behaviour of interest and prices under both a “technology boom-bust” driven by changes in expectation about TFP, and a “credit boom-bust” driven by changes in expectations about the efficiency of the financial sector. While the two scenarios are similar in that they both lead to a run-up and then sharp drop-off in new capital and debt, I show that the behaviour of interest and prices depends critically on the nature of the new-shock driving the overaccumulation. In particular, the boom-phase of the TFP boom-bust is characterized by below-trend inflation or deflation, whereas that of the credit boom-bust is characterized by above-trend but low inflation. In contrast, inflation falls below-trend in the bust phases of both. I show that consistent with results elsewhere in the literature, stricter inflationtargeting fails to pull the economy toward the efficient equilibrium during the boom phase of the TFP boom-bust. In contrast, stricter inflation targeting pushes the economy closer to the flexible-price response during the boom-phase of the credit boom-bust. In both cases however, conditional on realization of overaccumulation, inflation-targeting pulls the economy towards the flexible price equilibrium.