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Central Banking and Financial Stability in the Long Run

  • Jin Cao
  • Lorán Chollete
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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.

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File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2013/wp-cesifo-2013-06/cesifo1_wp4272.pdf
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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 4272.

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Date of creation: 2013
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Handle: RePEc:ces:ceswps:_4272
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  1. Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000. "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 611-38, August.
  2. Shin, Hyun Song, 2010. "Risk and Liquidity," OUP Catalogue, Oxford University Press, number 9780199546367, December.
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  6. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  7. Jin Cao & Gerhard Illing, 2012. ""Interest Rate Trap", or: Why Does the Central Bank Keep the Policy Rate too Low for too Long Time?," CESifo Working Paper Series 3794, CESifo Group Munich.
  8. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  9. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680, December.
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  11. Franklin Allen & Elena Carletti & Douglas Gale, 2009. "Interbank Market Liquidity and Central Bank Intervention," Economics Working Papers ECO2009/09, European University Institute.
  12. Cornes,Richard & Sandler,Todd, 1996. "The Theory of Externalities, Public Goods, and Club Goods," Cambridge Books, Cambridge University Press, number 9780521477185, Junio.
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