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Incorporating Financial Sector Risk into Monetary Policy Models: Application to Chile

  • Dale Gray
  • Carlos García
  • Leonardo Luna
  • Jorge E. Restrepo

This paper presents a model for the financial sector’s vulnerability and integrates it into a macroeconomic framework commonly used in monetary policymaking. The main question to answer with the integrated model is whether central banks should explicitly include the financial stability indicator in the reaction function of the monetary policy interest rate. Our results show that, in general, including the banking industry’s distance to default (dtd) in the central bank’s reaction function reduces both inflation and output volatility. In addition, the results are robust to different calibrations of the model. Actually, there is gained efficiency from including the dtd variable in the reaction function whenever the pass-through coefficient of the exchange rate is higher and when financial vulnerability has a greater effect on the exchange rate and GDP (or, conversely, a higher effect of GDP in banking sector capital, which is here called endogeneity).

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 553.

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Date of creation: Dec 2009
Date of revision:
Handle: RePEc:chb:bcchwp:553
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  1. Vasco Cúrdia & Michael Woodford, 2009. "Credit frictions and optimal monetary policy," BIS Working Papers 278, Bank for International Settlements.
  2. M. Tudela & G. Young, 2005. "A Merton-Model Approach To Assessing The Default Risk Of Uk Public Companies," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(06), pages 737-761.
  3. Dale F. Gray; & Robert C. Merton & Zvi Bodie, 2009. "New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability," Working Papers Central Bank of Chile 541, Central Bank of Chile.
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  15. Papa M'B. P. N'Diaye, 2009. "Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy," IMF Working Papers 09/257, International Monetary Fund.
  16. Lawrence Christiano & Roberto Motto & Massimo Rostagno, 2007. "Two Reasons Why Money and Credit May be Useful in Monetary Policy," NBER Working Papers 13502, National Bureau of Economic Research, Inc.
  17. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  18. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
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