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Monetary Policy Rules with Financial Instability

  • Sofia Bauducco
  • Ales Bulir
  • Martin Cihak

To provide a rigorous analysis of monetary policy in the face of financial instability, we extend the standard dynamic stochastic general equilibrium model to include a financial system. Our simulations suggest that if financial instability affects output and inflation with a lag, and if the central bank has privileged information about credit risk, monetary policy responding instantly to increased credit risk can trade off more output and inflation instability today for a faster return to the trend than a policy that follows the simple Taylor rule. This augmented rule leads in some parameterizations to improved outcomes in terms of long-term welfare, however, the welfare impacts of such a rule appear to be negligible.

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Paper provided by Czech National Bank, Research Department in its series Working Papers with number 2008/8.

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Date of creation: Dec 2008
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Handle: RePEc:cnb:wpaper:2008/8
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