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Central Banking and Financial Stability in the Long Run

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  • Jin Cao
  • Lorán Chollete

Abstract

Most theoretical central bank models use short horizons and focus on a single tradeoff. However, in reality central banks play complex, long horizon games and face more than one tradeoff. We account for these issues in a simple infinite horizon game with a novel tradeoff: higher rates deter financial imbalances, but lower rates reduce the likelihood of bankruptcy. We term these factors discipline and stability effects, respectively. The central bank’s welfare decreases with dependence between real and financial shocks, so it may reduce costs with correlation-indexed securities. Generally, independent central banks cannot attain both low inflation and financial stability.

Suggested Citation

  • Jin Cao & Lorán Chollete, 2013. "Central Banking and Financial Stability in the Long Run," CESifo Working Paper Series 4272, CESifo Group Munich.
  • Handle: RePEc:ces:ceswps:_4272
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    File URL: http://www.cesifo-group.de/DocDL/cesifo1_wp4272.pdf
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    References listed on IDEAS

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    7. Jin Cao & Gerhard Illing, 2011. ""Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?," Working Paper 2011/12, Norges Bank.
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    More about this item

    Keywords

    central bank; correlation-indexed security; discipline effect; stability effect;

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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