Monetary policy and fears of financial instability
AbstractExploiting a specific sunspot equilibrium in a standard forward-looking New Keynesian model, we present an example of a possible conflict between short-term price stability and financial stability. We find a conflict because the sunspot process consists of a self-fulfilling belief linking the stability of inflation to the smoothness of the interest rate path. A policy focusing only on a fixed-horizon inflation forecast neglects the potential effects of this belief on the variance of inflation. The nature of the conflict case is interpreted as evidence for the occasional relevance as well as the general tenuousness of the conflict case. The implementation of our example has led us, furthermore, to illustrate the lack of general applicability of the Bellman principle in dynamic programming for forward-looking models. Our result holds with respect to a more general (Nash-type) concept of optimality JEL Classification: C61, C62, E52, E58
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Find related papers by JEL classification:
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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