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Financial stability, interest-rate smoothing and equilibrium determinacy

  • Di Giorgio, Giorgio
  • Rotondi, Zeno

This paper examines the interaction between monetary policy and financial stability and provides an assessment of the implications of banks' risk management practices for monetary policy. By considering the desire of the central bank to stabilize different types of the "basis" risk as a contribution to financial stability, we derive a set of plausible interest-rate rules characterized by either backward or forward interest-rate smoothing. The paper investigates the determinacy conditions of the rational expectations equilibria obtained under such rules. Contrary to what previously found in the literature, we find that the practice of smoothing interest rates backward does not in general alleviate problems of equilibrium indeterminacy. Moreover, basis risk stabilization may lead to policy rules embedding "forward" interest-rate smoothing, where a new kind of indeterminacy may arise following excessive concern for financial stability.

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Article provided by Elsevier in its journal Journal of Financial Stability.

Volume (Year): 7 (2011)
Issue (Month): 1 (January)
Pages: 1-9

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Handle: RePEc:eee:finsta:v:7:y:2011:i:1:p:1-9
Contact details of provider: Web page: http://www.elsevier.com/locate/jfstabil

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  1. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
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  4. Frederic S. Mishkin, 1999. "Global Financial Instability: Framework, Events, Issues," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 3-20, Fall.
  5. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
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  7. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
  8. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  9. James Bullard & Kaushik Mitra, 2007. "Determinacy, Learnability, and Monetary Policy Inertia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(5), pages 1177-1212, 08.
  10. Andrew Crockett, 1997. "Why is financial stability a goal of public policy?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 7-36.
  11. Driffill, John & Rotondi, Zeno & Savona, Paolo & Zazzara, Cristiano, 2006. "Monetary policy and financial stability: What role for the futures market?," Journal of Financial Stability, Elsevier, vol. 2(1), pages 95-112, April.
  12. James B. Bullard & Eric Schaling, 2002. "Why the Fed should ignore the stock market," Review, Federal Reserve Bank of St. Louis, issue Mar., pages 35-42.
  13. David M. Wright & James V. Houpt, 1996. "An analysis of commercial bank exposure to interest rate risk," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Feb, pages 115-128.
  14. Basle Committee on Banking Supervision, 1997. "Release of PRINCIPLES FOR THE MANAGEMENT OF INTEREST RATE RISK," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Nov, pages 890-891.
  15. Giorgio Di Giorgio & Salvatore Nistico, 2007. "Monetary Policy and Stock Prices in an Open Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(8), pages 1947-1985, December.
  16. Andrew Crockett, 1997. "Why is financial stability a goal of public policy?," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 5-22.
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