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Monetary policy and fears of financial instability

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  • Brousseau, Vincent
  • Detken, Carsten

Abstract

Exploiting 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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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0089.

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Date of creation: Nov 2001
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Handle: RePEc:ecb:ecbwps:20010089

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  1. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 11-90, Wharton School Rodney L. White Center for Financial Research.
  2. Gary Gorton, 1986. "Banking panics and business cycles," Working Papers 86-9, Federal Reserve Bank of Philadelphia.
  3. Bennett T. McCallum, 1994. "Monetary Policy Rules and Financial Stability," NBER Working Papers 4692, National Bureau of Economic Research, Inc.
  4. Christopher Kent & Guy Debelle, 1999. "Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy," RBA Research Discussion Papers rdp1999-05, Reserve Bank of Australia.
  5. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Working Paper, Federal Reserve Bank of Richmond 88-01, Federal Reserve Bank of Richmond.
  6. Honkapohja, S. & Mitra, K., 2001. "Are Non-Fundamental Equilibria Learnable in Models of Monetary Policy?," University of Helsinki, Department of Economics, Department of Economics 501, Department of Economics.
  7. Frank Smets, 1997. "Financial asset prices and monetary policy: theory and evidence," BIS Working Papers 47, Bank for International Settlements.
  8. Christopher Kent & Philip Lowe, 1997. "Asset-price Bubbles and Monetary Policy," RBA Research Discussion Papers rdp9709, Reserve Bank of Australia.
  9. George G. Kaufman, 1998. "Central banks, asset bubbles, and financial stability," Working Paper Series, Federal Reserve Bank of Chicago WP-98-12, Federal Reserve Bank of Chicago.
  10. Timothy Cogley, 1999. "Should the Fed take deliberate steps to deflate asset price bubbles?," Economic Review, Federal Reserve Bank of San Francisco, pages 42-52.
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Cited by:
  1. Martin Cihák & Ales Bulir & Sofía Bauducco, 2008. "Taylor Rule Under Financial Instability," IMF Working Papers 08/18, International Monetary Fund.
  2. Baxa, Jaromír & Horváth, Roman & Vašíček, Bořek, 2013. "Time-varying monetary-policy rules and financial stress: Does financial instability matter for monetary policy?," Journal of Financial Stability, Elsevier, Elsevier, vol. 9(1), pages 117-138.
  3. Roman Horvath & Jaromir Baxa & Borek Vasicek, 2011. "How Does Monetary Policy Respond to Financial Stress?," EcoMod2011 2769, EcoMod.
  4. Albulescu, Claudiu Tiberiu, 2013. "Financial Stability and Monetary Policy: A Reduced-Form Model for the EURO Area," Journal for Economic Forecasting, Institute for Economic Forecasting, Institute for Economic Forecasting, vol. 0(1), pages 62-81, March.
  5. Uhlig, Harald, 2002. "One Money, but Many Fiscal Policies in Europe: What Are the Consequences?," CEPR Discussion Papers 3296, C.E.P.R. Discussion Papers.
  6. Bank for International Settlements, 2003. "Monetary stability, financial stability and the business cycle: five views," BIS Papers, Bank for International Settlements, number 18.
  7. Claudiu Tiberiu ALBULESCU, 2011. "Macro-Financial Risks and Central Banks: What Changes Has the Crisis Triggered?," Timisoara Journal of Economics, West University of Timisoara, Romania, Faculty of Economics and Business Administration, vol. 4(3(15)), pages 135-142.
  8. Mario Sarcinelli, 2003. "Crisi economiche e mercati finanziari:  di aiuto un nuovo ordine finanziario?," Moneta e Credito, Economia civile, vol. 56(224), pages 387-422.
  9. Sofía Bauducco & Aleš Bulir & Martin Èihák, 2011. "Monetary Policy Rules with Financial Instability," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, Charles University Prague, Faculty of Social Sciences, vol. 61(6), pages 545-565, December.
  10. Detken, Carsten & Smets, Frank, 2004. "Asset price booms and monetary policy," Working Paper Series, European Central Bank 0364, European Central Bank.
  11. Detken, Carsten & Gaspar, Vítor, 2003. "Maintaining price stability under free-floating: a fearless way out of the corner?," Working Paper Series, European Central Bank 0241, European Central Bank.
  12. Claudiu T. Albulescu & Cornel Oros, 2014. "The policy-mix in the Euro Area: The Role of Financial Stability," Economics Bulletin, AccessEcon, vol. 34(2), pages 705-717.

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