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

Listed author(s):
  • 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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File URL: http://si2.bcentral.cl/public/pdf/documentos-trabajo/pdf/dtbc553.pdf
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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
Handle: RePEc:chb:bcchwp:553
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  1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  2. 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 351-367, May.
  3. Rodrigo A. Alfaro & Carmen Gloria Silva, 2008. "Volatilidad de Indices Accionarios: El caso del IPSA," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 45(132), pages 217-233.
  4. Arnaud Jobert & Janet Kong & Jorge A Chan-Lau, 2004. "An Option-Based Approach to Bank Vulnerabilities in Emerging Markets," IMF Working Papers 04/33, International Monetary Fund.
  5. Merxe Tudela & Garry Young, 2003. "A Merton-model approach to assessing the default risk of UK public companies," Bank of England working papers 194, Bank of England.
  6. Jorge A Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities - A Survey," IMF Working Papers 06/149, International Monetary Fund.
  7. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  8. Douglas Laxton & Paolo Pesenti, 2003. "Monetary Rules for Small, Open, Emerging Economies," NBER Working Papers 9568, National Bureau of Economic Research, Inc.
  9. Jorge A Chan-Lau & Toni Gravelle, 2005. "The END; A New Indicator of Financial and Nonfinancial Corporate Sector Vulnerability," IMF Working Papers 05/231, International Monetary Fund.
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