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

This paper examines whether misspecification in credit market friction could be costly in the context of monetary policymaking. Using two widely known dynamic stochastic general equilibrium (DSGE) models, we simulate a hypothetical financial crisis and examine how each model performs when the misspecification occurs in the credit channel. We demonstrate that monetary policy suggested by misspecified models tends to destabilize the economy during crisis, even though one of the two models does reasonably well in estimating policy-invariant model parameters. We also show that the opportunity cost of using a misspecified model is high relative to the outcome achieved under a correctly specified model, particularly when public financial intermediation is available in the correctly specified model. Introducing labor-related variables in either the monetary policy rule or stabilization objectives has the potential of improving policy outcomes in the misspecified credit channel model.