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Like a Good Neighbor: Monetary Policy, Financial Stability, and the Distribution of Risk

  • Evan F. Koenig

    (Federal Reserve Bank of Dallas and Southern Methodist University)

In an economy in which debt obligations are fixed in nominal terms, a monetary policy focused narrowly on controlling inflation insulates lenders from aggregate output risk, leaving borrowers as residual claimants. This concentration of risk has the potential to exacerbate the financial distress associated with adverse supply shocks. A better risk distribution is obtained if the price level is allowed to rise whenever output is unexpectedly weak. Illustrative examples are presented in which an appropriately countercyclical inflation policy exactly reproduces the risk allocation that one would observe with perfect capital markets.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 9 (2013)
Issue (Month): 2 (June)
Pages: 57-82

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Handle: RePEc:ijc:ijcjou:y:2013:q:2:a:3
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  1. Bernanke, Ben S, 1995. "The Macroeconomics of the Great Depression: A Comparative Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(1), pages 1-28, February.
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  3. Kevin D. Sheedy, 2013. "Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting," CEP Discussion Papers dp1209, Centre for Economic Performance, LSE.
  4. Matthias Doepke, . "Inflation as a Redistribution Shock: Effects on Aggregates and Welfare," UCLA Economics Online Papers 412, UCLA Department of Economics.
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  6. Bohn, Henning, 1988. "Why do we have nominal government debt?," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 127-140, January.
  7. David Eagle & Dale Domian, 2005. "Quasi-Real Indexing-- The Pareto-Efficient Solution to Inflation Indexing," Finance 0509017, EconWPA.
  8. Ashoka Mody & Mark P. Taylor, 2003. "The High-Yield Spread as a Predictor of Real Economic Activity: Evidence of a Financial Accelerator for the United States," IMF Staff Papers, Palgrave Macmillan, vol. 50(3), pages 3.
  9. Allan Crawford & C├ęsaire A. Meh & Yaz Terajima, 2009. "Price-Level Uncertainty, Price-Level Targeting, and Nominal Debt Contracts," Bank of Canada Review, Bank of Canada, vol. 2009(Spring), pages 33-43.
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