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Incorporating Financial Sector Risk Into Monetary Policy Models

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Author Info

  • Leonardo Luna
  • Dale F. Gray
  • Jorge Restrepo
  • Carlos Garcia

Abstract

This paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. The main question to be answered with the integrated model is whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. It is found in general, that including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility. Moreover, the results are robust to different model calibrations: whenever exchange-rate pass-through is higher; financial vulnerability has a larger impact on the exchange rate, as well as on GDP (or the reverse, there is more effect of GDP on bank''s equity - i.e., what we call endogeneity), it is more efficient to include dtd in the reaction function.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 11/228.

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Length: 34
Date of creation: 01 Sep 2011
Date of revision:
Handle: RePEc:imf:imfwpa:11/228

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Related research

Keywords: Banking systems; Economic models; Financial risk; Financial sector; inflation; monetary policy; banking; central bank; banking system; probability of default; monetary fund; capital adequacy; banking sector; bank assets; monetary authority; sovereign risk; bank equity; monetary authorities; monetary economics; deposit insurance; banking industry; monetary policy rule; bank asset; banking sector assets; reserve requirements; central banking; bank behavior; aggregate demand; settlement system; optimal monetary policy; economic condition; bank vulnerabilities; monetary policy reaction function; subordinated debt; banking sector instability; bank risk; present value; bank debt; banking risk; banking asset; nonperforming loan; bank of england; bond indenture; bank policy;

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References

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  1. Vasco Curdia & Michael Woodford, 2008. "Credit Frictions and Optimal Monetary Policy," Discussion Papers 0809-02, Columbia University, Department of Economics.
  2. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
  3. Alasdair Scott & Pau Rabanal & Prakash Kannan, 2009. "Monetary and Macroprudential Policy Rules in a Model with House Price Booms," IMF Working Papers 09/251, International Monetary Fund.
  4. Papa M'B. P. N'Diaye, 2009. "Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy," IMF Working Papers 09/257, International Monetary Fund.
  5. Charles Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2004. "A model to analyse financial fragility," LSE Research Online Documents on Economics 24703, London School of Economics and Political Science, LSE Library.
  6. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2006. "A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy," NBER Working Papers 12637, National Bureau of Economic Research, Inc.
  7. M. Tudela & G. Young, 2005. "A Merton-Model Approach To Assessing The Default Risk Of Uk Public Companies," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(06), pages 737-761.
  8. Rodrigo A. Alfaro & Carmen Gloria Silva, 2008. "Volatilidad de Indices Accionarios: El caso del IPSA," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 45(132), pages 217-233.
  9. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2007. "New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability," NBER Working Papers 13607, National Bureau of Economic Research, Inc.
  10. Lawrence Christiano & Roberto Motto & Massimo Rostagno, 2007. "Two Reasons Why Money and Credit May be Useful in Monetary Policy," NBER Working Papers 13502, National Bureau of Economic Research, Inc.
  11. Arnaud Jobert & Janet Kong & Jorge A. Chan-Lau, 2004. "An Option-Based Approach to Bank Vulnerabilities in Emerging Markets," IMF Working Papers 04/33, International Monetary Fund.
  12. Michael T. Gapen & Dale F. Gray & Cheng Hoon Lim & Yingbin Xiao, 2005. "Measuring and Analyzing Sovereign Risk with Contingent Claims," IMF Working Papers 05/155, International Monetary Fund.
  13. Jorge A. Chan-Lau & Toni Gravelle, 2005. "The End," IMF Working Papers 05/231, International Monetary Fund.
  14. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
  15. Martin Cihák & Ales Bulir & Sofía Bauducco, 2008. "Taylor Rule Under Financial Instability," IMF Working Papers 08/18, International Monetary Fund.
  16. Dale F. Gray & James P Walsh, 2008. "Factor Model for Stress-Testing with a Contingent Claims Model of the Chilean Banking System," IMF Working Papers 08/89, International Monetary Fund.
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