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Financial shocks, financial stability, and optimal Taylor rules

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  • Verona, Fabio
  • Martins, Manuel M.F.
  • Drumond, Inês

Abstract

We assess the performance of optimal Taylor-type interest rate rules, with and without reaction to financial variables, in stabilizing an economy following financial shocks. The analysis is conducted in a DSGE model with loan and bond markets, each featuring financial frictions. This allows for a wide set of financial shocks and transmission mechanisms and can be calibrated to match the bond-to-bank finance ratio featured in the US financial system. Overall, we find that monetary policy that reacts to credit growth, a form of the so-called “leaning against the wind”, improves the ability of the central bank to achieve its mandate in the wake of financial shocks. The specific policy implications depend partly on the origin and the persistence of the financial shock, but overall not on the assignment of a mandate for financial stability in the central bank’s objective function.

Suggested Citation

  • Verona, Fabio & Martins, Manuel M.F. & Drumond, Inês, 2017. "Financial shocks, financial stability, and optimal Taylor rules," Journal of Macroeconomics, Elsevier, vol. 54(PB), pages 187-207.
  • Handle: RePEc:eee:jmacro:v:54:y:2017:i:pb:p:187-207
    DOI: 10.1016/j.jmacro.2017.04.004
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    15. Christian Friedrich & Kristina Hess & Rose Cunningham, 2019. "Monetary Policy and Financial Stability: Cross‐Country Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 51(2-3), pages 403-453, March.
    16. Kühl, Michael, 2014. "Mitigating financial stress in a bank-financed economy: Equity injections into banks or purchases of assets?," Discussion Papers 19/2014, Deutsche Bundesbank.
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    More about this item

    Keywords

    Financial shocks; Financial stability; Optimal Taylor rules; DSGE model; Bond market; Loan market;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

    Statistics

    Access and download statistics

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