Financial Vulnerability and Monetary Policy

Tobias Adrian and Fernando Duarte

No 12680, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We present a microfounded New Keynesian model that features financial vulnerabilities. Financial intermediaries' occasionally binding value at risk constraints give rise to variation in the pricing of risk that generate time varying risk in the conditional mean and volatility of the output gap. The conditional mean and volatility are negatively related: during times of easy financial conditions, growth tends to be high, and risk tends to be low. Monetary policy affects output directly via the IS curve, and indirectly via the pricing of risk that relates to the tightness of the value at risk constraint. The optimal monetary policy rule always depends on financial vulnerabilities in addition to the output gap, inflation, and the natural rate. We show that a classic Taylor rule exacerbates deviations of the output gap from its target value of zero relative to an optimal interest rate rule that includes vulnerability. Simulations show that optimal policy significantly increases welfare relative to a classic Taylor rule. Alternative policy paths using historical examples illustrate the usefulness of the proposed policy rule.

Keywords: Monetary policy; Macro-finance; Financial stability (search for similar items in EconPapers)
JEL-codes: E52 G10 G12 (search for similar items in EconPapers)
Date: 2018-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (17)

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Related works:
Working Paper: Financial Vulnerability and Monetary Policy (2017)
Working Paper: Financial vulnerability and monetary policy (2016)
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