Incorporating Financial Sector Risk into Monetary Policy Models: Application to Chile
AbstractThis 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 InfoPaper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 553.
Date of creation: Dec 2009
Date of revision:
Other versions of this item:
- Dale F. Gray & Carlos J. GarcÃa & Leonardo Luna & Jorge E. Restrepo, 2011. "Incorporating Financial Sector Risk Into Monetary Policy Models: Application to Chile," Central Banking, Analysis, and Economic Policies Book Series, in: Rodrigo Alfaro (ed.), Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 6, pages 159-197 Central Bank of Chile.
- Dale Gray & Carlos GarcÃa T. & Leonardo Luna B. & Jorge E. Restrepo L., 2009. "Incorporating Financial Sector Risk Into Monetary Policy Models: Application to Chile," Journal EconomÃa Chilena (The Chilean Economy), Central Bank of Chile, vol. 12(2), pages 11-33, August.
- Dale F. Gray & Carlos Garcia & Leonardo Luna & Jorge Restrepo, 2009. "Incorporation financial sector risk into monetary policy models: application to Chile," ILADES-Georgetown University Working Papers, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines inv229, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
- 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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