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Incorporating Financial Sector Risk Into Monetary Policy Models: Application to Chile

In: Financial Stability, Monetary Policy, and Central Banking

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  • Dale F. Gray

    (International Monetary Fund)

  • Carlos J. García

    (Ilades–Universidad Alberto Hurtado)

  • Leonardo Luna

    (Transelec, Chile)

  • Jorge E. Restrepo

    (Central Bank of Chile)

Abstract

This paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. The main question to be answered with the integrated model is whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. It is found in general, that including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility. Moreover, the results are robust to different model calibrations. Indeed, it is more efficient to include dtd in the reaction function with higher coefficient of exchange rate pass through, and with a larger impact of financial vulnerability on the exchange rate, as well as on GDP (or the reverse, there is more effect of GDP on bank’s equity—i.e., what we call endogeneity).

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This chapter was published in: Rodrigo Alfaro (ed.) Financial Stability, Monetary Policy, and Central Banking, , chapter 06, pages 159-197, 2011.

This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v15c06pp159-197.

Handle: RePEc:chb:bcchsb:v15c06pp159-197

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  1. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  2. Jorge A. Chan-Lau & Toni Gravelle, 2005. "The End," IMF Working Papers 05/231, International Monetary Fund.
  3. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  4. M. Tudela & G. Young, 2005. "A Merton-Model Approach To Assessing The Default Risk Of Uk Public Companies," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(06), pages 737-761.
  5. Laxton, Douglas & Pesenti, Paolo, 2003. "Monetary rules for small, open, emerging economies," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1109-1146, July.
  6. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  7. Arnaud Jobert & Janet Kong & Jorge A. Chan-Lau, 2004. "An Option-Based Approach to Bank Vulnerabilities in Emerging Markets," IMF Working Papers 04/33, International Monetary Fund.
  8. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
  9. Rodrigo A. Alfaro & Carmen Gloria Silva, 2008. "Volatilidad de Indices Accionarios: El caso del IPSA," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 45(132), pages 217-233.
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Cited by:
  1. Renata Karkowska, 2013. "Instability In The Cee Banking System. Evidence From The Recent Financial Crisis," CES Working Papers, Centre for European Studies, Alexandru Ioan Cuza University, vol. 5, pages 535-547, December.
  2. International Monetary Fund, 2011. "Financial Linkages Across Korean Banks," IMF Working Papers 11/201, International Monetary Fund.

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