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Financial Stability and Optimal Interest Rate Policy

Author

Listed:
  • Andrea Ajello

    (Federal Reserve Board)

  • Thomas Laubach

    (Federal Reserve Board)

  • David López-Salido

    (Federal Reserve Board)

  • Taisuke Nakata

    (Federal Reserve Board)

Abstract

We study optimal interest rate policy in a New Keynesian framework in which the model economy can experience financial crises and the probability of a crisis depends on credit conditions. We find that the optimal response of the shortterm interest rate to credit conditions is (very) small in the model calibrated to match the historical relationship between credit conditions, output, inflation, and likelihood of financial crises. Given the imprecise estimates of key parameters, we also study optimal policy under parameter uncertainty. We find that Bayesian and robust central banks will respond more aggressively to financial instability when the probability and severity of financial crises are uncertain.

Suggested Citation

  • Andrea Ajello & Thomas Laubach & David López-Salido & Taisuke Nakata, 2019. "Financial Stability and Optimal Interest Rate Policy," International Journal of Central Banking, International Journal of Central Banking, vol. 15(1), pages 279-326, March.
    • Handle: RePEc:ijc:ijcjou:y:2019:q:1:a:7
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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises

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