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Abstract

This paper presents a model for the financial sector’s vulnerability and integrates it into a macroeconomic framework commonly used in monetary policymaking. The main question to answer with the integrated model is whether central banks should explicitly include the financial stability indicator in the reaction function of the monetary policy interest rate. Our results show that, in general, including the banking industry’s distance to default (dtd) in the central bank’s reaction function reduces both inflation and output volatility. In addition, the results are robust to different calibrations of the model. Actually, there is gained efficiency from including the dtd variable in the reaction function whenever the pass-through coefficient of the exchange rate is higher and when financial vulnerability has a greater effect on the exchange rate and GDP (or, conversely, a higher effect of GDP in banking sector capital, which is here called endogeneity).

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 553.

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Date of creation: Dec 2009
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Handle: RePEc:chb:bcchwp:553

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Find related papers by JEL classification:

• E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
• E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
• E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
• E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
• F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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1. Dale F. Gray; & Robert C. Merton & Zvi Bodie, 2009. "New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability," Working Papers Central Bank of Chile 541, Central Bank of Chile.
   
   • Dale F. Gray & Robert C. Merton & Zvi Bodie, 2007. "New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability," NBER Working Papers 13607, National Bureau of Economic Research, Inc.
2. 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.
   
   • Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
   • Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
3. Papa M'B. P. N'Diaye, 2009. "Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy," IMF Working Papers 09/257, International Monetary Fund.
4. Vasco Curdia & Michael Woodford, 2008. "Credit Frictions and Optimal Monetary Policy," Discussion Papers 0809-02, Columbia University, Department of Economics.
   
   • Vasco Cúrdia & Michael Woodford, 2008. "Credit frictions and optimal monetary policy," Working Paper Research 146, National Bank of Belgium.
   • Vasco Cúrdia & Michael Woodford, 2009. "Credit frictions and optimal monetary policy," BIS Working Papers 278, Bank for International Settlements.
5. 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.
6. Martin Cihák & Ales Bulir & Sofía Bauducco, 2008. "Taylor Rule Under Financial Instability," IMF Working Papers 08/18, International Monetary Fund.
7. Charles Goodhart & Pojanart Sunirand & Dimitrios Tsomocos, 2006. "A model to analyse financial fragility," Economic Theory, Springer, vol. 27(1), pages 107-142, 01.
   
   • Charles A.E. Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2003. "A Model to Analyse Financial Fragility," OFRC Working Papers Series 2003fe13, Oxford Financial Research Centre.
8. 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.
9. Merxe Tudela & Garry Young, 2003. "A Merton-model approach to assessing the default risk of UK public companies," Bank of England working papers 194, Bank of England.
   
   • 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.
   • Tudela, Merxe & Garry Young, 2003. "A Merton Model Approach to Assessing the Default Risk of UK Public Companies," Royal Economic Society Annual Conference 2003 207, Royal Economic Society.
10. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
11. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2006. "A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy," NBER Working Papers 12637, National Bureau of Economic Research, Inc.
12. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
13. Michael T. Gapen & Dale F. Gray & Cheng Hoon Lim & Yingbin Xiao, 2005. "Measuring and Analyzing Sovereign Risk with Contingent Claims," IMF Working Papers 05/155, International Monetary Fund.
14. Prakash Kannan & Pau Rabanal & Alasdair M. Scott, 2012. "Monetary and Macroprudential Policy Rules in a Model with House Price Booms," The B.E. Journal of Macroeconomics, De Gruyter, vol. 12(1), pages 16.
    
    • Alasdair Scott & Pau Rabanal & Prakash Kannan, 2009. "Monetary and Macroprudential Policy Rules in a Model with House Price Booms," IMF Working Papers 09/251, International Monetary Fund.
15. Jorge A. Chan-Lau & Toni Gravelle, 2005. "The END: A New Indicator of Financial and Nonfinancial Corporate Sector Vulnerability," IMF Working Papers 05/231, International Monetary Fund.
16. Dale F. Gray & James P Walsh, 2008. "Factor Model for Stress-testing with a Contingent Claims Model of the Chilean Banking System," IMF Working Papers 08/89, International Monetary Fund.
17. Lawrence Christiano & Roberto Motto & Massimo Rostagno, 2007. "Two Reasons Why Money and Credit May be Useful in Monetary Policy," NBER Working Papers 13502, National Bureau of Economic Research, Inc.

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Cited by:

1. International Monetary Fund, 2011. "Financial Linkages across Korean Banks," IMF Working Papers 11/201, International Monetary Fund.

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