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Monetary policy and fears of financial instability

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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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Bibliographic 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
Date of revision:
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

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  1. Honkapohja, Seppo & Mitra, Kaushik, 2004. "Are non-fundamental equilibria learnable in models of monetary policy?," Journal of Monetary Economics, Elsevier, vol. 51(8), pages 1743-1770, November.
  2. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers 11-90, Wharton School Rodney L. White Center for Financial Research.
  3. 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.
  4. Smets, Frank, 1997. "Financial Asset Prices and Monetary Policy: Theory and Evidence," CEPR Discussion Papers 1751, C.E.P.R. Discussion Papers.
  5. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Economic Review, Federal Reserve Bank of Richmond, issue May, pages 3-22.
  6. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.
  7. George G. Kaufman, 1998. "Central banks, asset bubbles, and financial stability," Working Paper Series WP-98-12, Federal Reserve Bank of Chicago.
  8. 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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Citations

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Cited by:
  1. Jaromír Baxa & Roman Horváth & Borek Vasícek, 2011. "Monetary Policy Rules and Financial Stress: Does Financial Instability Matter for Monetary," Working Papers wpdea1101, Department of Applied Economics at Universitat Autonoma of Barcelona.
  2. Sofía Bauducco & Aleš Bulíø & 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, vol. 61(6), pages 545-565, December.
  3. Martin Cihák & Ales Bulir & Sofía Bauducco, 2008. "Taylor Rule Under Financial Instability," IMF Working Papers 08/18, International Monetary Fund.
  4. Uhlig, H.F.H.V.S., 2002. "One Money, But Many Fiscal Policies in Europe: What are the Consequences?," Discussion Paper 2002-32, Tilburg University, Center for Economic Research.
  5. 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.
  6. Carsten Detken & Frank Smets, 2004. "Asset price booms and monetary policy," Working Paper Series 364, European Central Bank.
  7. Bank for International Settlements, 2003. "Monetary stability, financial stability and the business cycle: five views," BIS Papers, Bank for International Settlements, number 18, March.
  8. 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.
  9. 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, vol. 9(1), pages 117-138.

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