an increase in general riskiness) is also worth highlighting: output growth falls, credit spreads rise, real credit growth falls, and real house price inflation falls. This is all as one would expect from the discussion above regarding the risk-taking channel. In both countries, inflation also rises when macroeconomic volatility increases. Charts 4a and 4b show historical decompositions derived using the posterior means of the distribution of the coefficient estimates. As there is rather a lot of information to digest in these decompositions, we show just the main variables of interest: the policy rate, and the four-quarter growth rates of output, real credit and real house prices. We also combine the  6  BIS Review 111/2010  impact of the aggregate demand and supply shocks into a single composite factor, and do the same with the credit demand and credit supply shocks so as to focus more clearly on the impact of monetary policy and macroeconomic volatility. There are a number of points to be made. First, monetary policy (the green bars) during the 2002–5 period is loose relative to the estimated historical reaction function not only in the United States – as might be expected given the evidence from Chart 1 – but also, more surprisingly, in the United Kingdom. In the United States, the Federal Funds rate is, on average, 1.5 percentage points below the rate that would have obtained if the estimated reaction function had applied. In the United Kingdom, the corresponding figure is 2.1 percentage points.
Households live forever and have standard intertemporal preferences over consumption (Ct) and hours worked (Ht). Investment (It), which is subject to adjustment costs, cannot be funded directly by households and instead must be financed by borrowing from a bank. Bank loans (Lt) are financed by the capital of bankers (Bt) and deposits (Dt) from households. Banks are owned and run by bankers. A proportion (1-γ) of bankers die at the end of each period and are replaced by a new generation. Bankers reinvest all their earnings in the capital of the bank whilst they live, and leave their net wealth to households when they die. In log-linear form (carets denote log-deviations from steady-state), the standard block of the model is described by: 1)  Market-clearing condition for output (Yt);  2)  Production function (Zt is TFP and Kt is capital);  3)  Labour market equilibrium (Xt is marginal costs);  4)  Price of physical capital (qt);  5)  Return on capital (rkt);  6)  Law of motion for physical capital;  7)  Consumption Euler equation (rnt is deposit rate);  8)  New Keynesian Phillips curve (πt is inflation rate). The special ingredient is a moral hazard friction in the banking sector.