Financial Variables in a Policy Rule: Does It Bring Macroeconomic Benefits?

Jan Žáček

No 2016/25, Working Papers IES from Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies

Abstract: After the recent financial crisis of 2007, a connection between monetary policy and financial stability has started to be thoroughly investigated. One of the particular areas of this research field deals with the role of various financial variables in the monetary policy rules. The main purpose of this research is to find whether direct incorporation of the financial variables in the monetary policy rule can bring macroeconomic benefits in terms of lower volatility of inflation and output. So far, the main emphasis of the research has been placed on the investigation of the augmented Taylor rules in the context of a closed economy. This paper sheds light on the performance of the augmented Taylor rules in a small open economy. For this purpose, a New Keynesian DSGE model with two types of financial frictions is constructed. The model is calibrated for the Czech Republic. This work provides four conclusions. First, incorporation of the financial variables (asset prices and the volume of credit) in the monetary policy rule is beneficial for macroeconomic stabilization in terms of lower implied volatilities of inflation and output. Second, the usefulness of the augmented monetary policy rule is the most apparent in case of the shock originating abroad. Third, there is a strong link between the financial and the real side of an economy. Fourth, if the banking sector experiences a sharp drop in bank capital that brings this sector into decline, activity in the whole economy deteriorates and monetary policy is not able to achieve macroeconomic stability using its conventional tools.

Keywords: DSGE models; financial imperfections; inflation targeting; monetary policy (search for similar items in EconPapers)
JEL-codes: E31 E43 E52 E58 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2016-12, Revised 2016-12
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-tra
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Related works:
Journal Article: Financial Variables in a Policy Rule: Does It Bring Macroeconomic Benefits? (2019)
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