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Price Versus Financial Stability: A role for money in Taylor rules?

John Keating and Andrew Smith ()

No 201307, WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS from University of Kansas, Department of Economics

Abstract: This paper analyzes optimal monetary policy in a standard New-Keynesian model augmented with a financial sector. The banks in the model are subject to shocks which impede their ability and willingness to produce financial assets. We show these financial market supply shocks decrease both the natural rates of output and interest. The implication is that an optimizing central bank with real time data on only inflation, output, interest rate spreads and monetary aggregates will respond positively to the growth rate of monetary aggregates which signal movement in the natural rate from these financial shocks. This simple rule is implementable by central banks as it makes the policy instrument a function of only observables and does not require precise knowledge of the model or the parameters. The key is the use of the Divisia monetary aggregate which provides a parameter- and estimation- free approximation to the the true monetary aggregate. We show policy rules reacting to the Divisia monetary aggregate have well-behaved determinacy properties - satisfying a novel Taylor principle for monetary aggregates. Finally, we conclude with a minimax robust policy prescription given the uncertainty surrounding parameters driving the financial and other structural shocks.

Keywords: Monetary Aggregates; Optimal Monetary Policy; Taylor Rules; Financial Sector (search for similar items in EconPapers)
JEL-codes: C43 E32 E41 E44 E51 E52 E58 E60 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
Date: 2013-10
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