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Monetary policy and fears of financial instability

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Author Info
Carsten Detken () (European Central Bank, Kaiserstrasse 29, Postfach 16 03 19, 60066 Frankfurt am Main, Germany.)
Vincent Brousseau () (European Central Bank, Kaiserstrasse 29, Postfach 16 03 19, 60066 Frankfurt am Main, Germany.)

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Abstract

Exploiting a specific sunspot equilibrium in a standard forward-looking New Keynsian 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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Publisher Info
Paper provided by European Central Bank in its series Working Paper Series with number 089.

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Length: 46 pages
Date of creation: Nov 2001
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Handle: RePEc:ecb:ecbwps:20010089

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Related research
Keywords: Financial stability; price stability; optimal monetary policy; sunspot equilibria; Bellman principle; time inconsistency.;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  2. Ester Faia, 2001. "Stabilization policy in a two country model and the role of financial frictions," Working Paper Series 056, European Central Bank. [Downloadable!]
  3. Honkapohja, Seppo & Mitra, Kaushik, 2001. "Are Non-Fundamental Equilibria Learnable in Models of Monetary Policy?," CEPR Discussion Papers 2846, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Günter Coenen, 2000. "Asymptotic confidence bands for the estimated autocovariance and autocorrelation functions of vector autoregressive models," Working Paper Series 09, European Central Bank. [Downloadable!]
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  5. Bernanke, Ben S & Woodford, Michael, 1997. "Inflation Forecasts and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 653-84, November.
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. George W. Evans & Seppo Honkapohja, 2002. "Monetary policy; expectations and commitment," Working Paper Series 124, European Central Bank. [Downloadable!]
    Other versions:
  2. Martin Cihák & Sofia Bauducco & Ales Bulir, 2008. "Taylor Rule Under Financial Instability," IMF Working Papers 08/18, International Monetary Fund. [Downloadable!]
  3. Uhlig, H., 2002. "One money, but many fiscal policies in Europe : what are the consequences?," Discussion Paper 32, Tilburg University, Center for Economic Research. [Downloadable!]
    Other versions:
  4. Sofia Bauducco & Ales Bulir & Martin Cihak, 2008. "Monetary policy rules with financial instability," Working Papers 2008/8, Czech National Bank, Research Department. [Downloadable!]
  5. Carsten Detken & Frank Smets, 2004. "Asset price booms and monetary policy," Working Paper Series 364, European Central Bank. [Downloadable!]
  6. Carsten Detken & Vitor Gaspar, 2003. "Maintaining price stability under free-floating: a fearless way out of the corner?," Working Paper Series 241, European Central Bank. [Downloadable!]
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