Optimal Policy Implications of Financial Uncertainty

Zeynep Kantur () and Gülserim Özcan

MPRA Paper from University Library of Munich, Germany

Abstract: In addition to the stabilization of inflation and output gap, the responsibility of preventing financial crises and providing stable financial system is assumed by the central banks. In the aftermath of the Great Recession, the policymakers gave financial stability mandate more prominence to preemptively obliterate the fluctuations in the financial market. New models with alternative policy tools have emerged during this period to analyze the impact of financial shocks, and their linkages with the real economy. However, for the policymaker, it might not be possible to verify these models with existing information, which leads to uncertainty. This paper proposes robust optimal policy under uncertainty in response to financial and inflation shocks by acknowledging financial stability as an explicit objective of monetary policy. To do so, we extend the framework of De Paoli and Paustian (2017) by introducing model misspecification. We show that model ambiguity in the financial side requires a passive monetary policy stance. However, if the uncertainty originates from the supply side of the economy, an aggressive response of interest rate is required. We also show the contribution of an additional tool to the dynamics of the economy.

Keywords: Financial Uncertainty; Financial Stability; Optimal Monetary Policy; Robust Control (search for similar items in EconPapers)
JEL-codes: D81 E44 E52 E58 (search for similar items in EconPapers)
Date: 2019-08-15
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:95920

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