Monetary policy games, financial instability and incomplete information

Charles Richard Barrett, Ioanna Kokores and Somnath Sen
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Charles Richard Barrett: University of Birmingham
Somnath Sen: University of Birmingham

Annals of Finance, 2016, vol. 12, issue 2, No 2, 178 pages

Abstract: Abstract In the aftermath of the recent global financial crisis, monetary authorities, while pursuing traditional objectives, such as the control of inflation, are also eager to promote financial stability. In this paper, we model the strategic interaction of the central bank and the financial sector and explore a simple monetary policy game with perceived substantial risks to financial stability, where the central bank can be of two types, one pursuing strict inflation-targeting and the other concerned with affecting the expectations formed by the financial sector participants; however, the financial sector is unsure which, due to incomplete information. The conclusion is that for small shocks to inflation there is a pooling equilibrium, whereas for larger shocks there is separation. In the latter case, the central bank that has an explicit financial stability concern is willing to exercise more muted control to inflation in order to reinforce the safety of the financial sector.

Keywords: Monetary policy; Central bank; Financial stability; Strategic behavior; Incomplete information (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 E61 (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1007/s10436-016-0276-6

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