Financial Crises, Unconventional Monetary Policy Exit Strategies, and Agents’ Expectations

This paper studies the implications of exit strategies from unconventional monetary policy. Using a Markov switching DSGE model with financial frictions, agents in the model have rational expectations about the probability of financial crises, the probability of an unconventional response to crises, and the exit strategy used. Selling offassets quickly produces a double-dip recession; in contrast, a slow unwind generates a smooth recovery. Expectations about the exit strategy matter for the initial effectiveness of intervention. Increasing the probability of an unconventional response to crises creates distortions in pre-crisis variables that depend upon the exit strategy. The welfare benefits of increasing the probability of unconventional policy may differ ex-ante versus ex-post, as can the preferred exit strategy.