Financial shocks,financial stability,and optimal Taylor rules |
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| Institution: | 1. Bank of Finland, Monetary Policy and Research Department, Finland, and University of Porto, CEF.UP, Portugal;2. University of Porto, Faculty of Economics and CEF.UP, Portugal;3. Banco de Portugal, Financial Stability Department, and University of Porto, CEF.UP, Portugal;1. Wheaton College, Department of Business and Economics, 501 College Avenue, Wheaton, IL 60187, USA;2. Universidad de los Andes, Department of Economics, Calle 19A # 1–37 Este, Bloque W., Bogotá, Colombia;1. Ricercatore, Dipartimento di Economia, Metodi Quantitivi e Strategie di Impresa, Università degli Studi di Milano Bicocca, Piazza Ateneo Nuovo 1, Milano 20126, Italy;2. Professor of Economics and Herman Lay Professor of Private Enterprise, Hankamer School of Business, Baylor University, One Bear Place #98003, Waco, TX 76798 United States |
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| Abstract: | We assess the performance of optimal Taylor-type interest rate rules, with and without reaction to financial variables, in stabilizing an economy following financial shocks. The analysis is conducted in a DSGE model with loan and bond markets, each featuring financial frictions. This allows for a wide set of financial shocks and transmission mechanisms and can be calibrated to match the bond-to-bank finance ratio featured in the US financial system. Overall, we find that monetary policy that reacts to credit growth, a form of the so-called “leaning against the wind”, improves the ability of the central bank to achieve its mandate in the wake of financial shocks. The specific policy implications depend partly on the origin and the persistence of the financial shock, but overall not on the assignment of a mandate for financial stability in the central bank’s objective function. |
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