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Central Banking and Financial Stability in the Long Run

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  • Jin Cao
  • Lorán Chollete
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    Abstract

    Most theoretical central bank models use short horizons and focus on a single tradeoff. However, in reality central banks play complex, long horizon games and face more than one tradeoff. We account for these issues in a simple infinite horizon game with a novel tradeoff: higher rates deter financial imbalances, but lower rates reduce the likelihood of bankruptcy. We term these factors discipline and stability effects, respectively. The central bank’s welfare decreases with dependence between real and financial shocks, so it may reduce costs with correlation-indexed securities. Generally, independent central banks cannot attain both low inflation and financial stability.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2013/wp-cesifo-2013-06/cesifo1_wp4272.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 4272.

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    Date of creation: 2013
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    Handle: RePEc:ces:ceswps:_4272

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    Related research

    Keywords: central bank; correlation-indexed security; discipline effect; stability effect;

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    1. Robert J. Barro & David B. Gordon, 1984. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
    2. Xavier Freixas & Bruno Parigi & Jean Charles Rochet, 1998. "Systemic risk, interbank relations and liquidity provision by the Central Bank," Economics Working Papers 440, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 1999.
    3. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
    4. Franklin Allen & Elena Carletti & Douglas Gale, 2009. "Interbank Market Liquidity and Central Bank Intervention," Economics Working Papers ECO2009/09, European University Institute.
    5. Shin, Hyun Song, 2010. "Risk and Liquidity," OUP Catalogue, Oxford University Press, number 9780199546367.
    6. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
    7. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
    8. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, December.
    9. Jin Cao & Gerhard Illing, 2012. ""Interest Rate Trap", or: Why Does the Central Bank Keep the Policy Rate too Low for too Long Time?," CESifo Working Paper Series 3794, CESifo Group Munich.
    10. Anil K. Kashyap & Jeremy C. Stein, 2012. "The Optimal Conduct of Monetary Policy with Interest on Reserves," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 266-82, January.
    11. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680.
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