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Price Versus Financial Stability: A role for money in Taylor rules?

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  • John Keating

    (Department of Economics, The University of Kansas)

  • Andrew Lee Smith

    (Department of Economics, The University of Kansas)

Abstract

This paper analyzes optimal monetary policy in a standard New-Keynesian model augmented with a financial sector. The banks in the model are subject to shocks which impede their ability and willingness to produce financial assets. We show these financial market supply shocks decrease both the natural rates of output and interest. The implication is that an optimizing central bank with real time data on only inflation, output, interest rate spreads and monetary aggregates will respond positively to the growth rate of monetary aggregates which signal movement in the natural rate from these financial shocks. This simple rule is implementable by central banks as it makes the policy instrument a function of only observables and does not require precise knowledge of the model or the parameters. The key is the use of the Divisia monetary aggregate which provides a parameter- and estimation- free approximation to the the true monetary aggregate. We show policy rules reacting to the Divisia monetary aggregate have well-behaved determinacy properties - satisfying a novel Taylor principle for monetary aggregates. Finally, we conclude with a minimax robust policy prescription given the uncertainty surrounding parameters driving the financial and other structural shocks.

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Bibliographic Info

Paper provided by University of Kansas, Department of Economics in its series WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS with number 201307.

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Length: 31 pages
Date of creation: Oct 2013
Date of revision:
Handle: RePEc:kan:wpaper:201307

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Keywords: Monetary Aggregates; Optimal Monetary Policy; Taylor Rules; Financial Sector;

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  1. Faia, Ester & Monacelli, Tommaso, 2007. "Optimal interest rate rules, asset prices, and credit frictions," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 31(10), pages 3228-3254, October.
  2. Jordi Gali & J. David Lopez-Salido & Javier Valles, 2002. "Technology Shocks and Monetary Policy: Assessing the Fed's Performance," NBER Working Papers 8768, National Bureau of Economic Research, Inc.
  3. William Poole, 1969. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Special Studies Papers, Board of Governors of the Federal Reserve System (U.S.) 2, Board of Governors of the Federal Reserve System (U.S.).
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  5. Dellas, H. & Diba, B. & Loisel, O., 2010. "Financial Shocks and Optimal Policy," Working papers, Banque de France 277, Banque de France.
  6. Javier Andrés & J. David López-Salido & Edward Nelson, 2007. "Money and the natural rate of interest: structural estimates for the United States and the Euro area," Working Papers, Federal Reserve Bank of St. Louis 2007-005, Federal Reserve Bank of St. Louis.
  7. Barnett, William A., 1978. "The user cost of money," Economics Letters, Elsevier, Elsevier, vol. 1(2), pages 145-149.
  8. William A Barnett & Marcelle Chauvet, 2011. "Financial Aggregation And Index Number Theory," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., World Scientific Publishing Co. Pte. Ltd., volume 2, number 7580.
  9. Belongia, Michael T, 1996. "Measurement Matters: Recent Results from Monetary Economics Reexamined," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(5), pages 1065-83, October.
  10. Helge Berger & Henning Weber, 2012. "Money As Indicator for the Natural Rate of Interest," IMF Working Papers 12/6, International Monetary Fund.
  11. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
  12. William Barnett & Apostolos Serletis & W. Erwin Diewert, 2005. "The Theory of Monetary Aggregation (book front matter)," Macroeconomics, EconWPA 0511008, EconWPA.
  13. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2963, C.E.P.R. Discussion Papers.
  14. Diewert, W. E., 1976. "Exact and superlative index numbers," Journal of Econometrics, Elsevier, Elsevier, vol. 4(2), pages 115-145, May.
  15. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 36, pages 394.
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Cited by:
  1. John Keating & Andrew Lee Smith, 2013. "Determinacy and Indeterminacy in Monetary Policy Rules with Money," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS, University of Kansas, Department of Economics 201310, University of Kansas, Department of Economics.

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