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Monetary policy and fears of financial instability

  • Brousseau, Vincent
  • Detken, Carsten

Exploiting a specific sunspot equilibrium in a standard forward-looking New Keynesian model, we present an example of a possible conflict between short-term price stability and financial stability. We find a conflict because the sunspot process consists of a self-fulfilling belief linking the stability of inflation to the smoothness of the interest rate path. A policy focusing only on a fixed-horizon inflation forecast neglects the potential effects of this belief on the variance of inflation. The nature of the conflict case is interpreted as evidence for the occasional relevance as well as the general tenuousness of the conflict case. The implementation of our example has led us, furthermore, to illustrate the lack of general applicability of the Bellman principle in dynamic programming for forward-looking models. Our result holds with respect to a more general (Nash-type) concept of optimality JEL Classification: C61, C62, E52, E58

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Paper provided by European Central Bank in its series Working Paper Series with number 0089.

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Date of creation: Nov 2001
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Handle: RePEc:ecb:ecbwps:20010089
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  1. Charles W. Calomiris & Gary Gorton, 1991. "The Origins of Banking Panics: Models, Facts, and Bank Regulation," NBER Chapters, in: Financial Markets and Financial Crises, pages 109-174 National Bureau of Economic Research, Inc.
  2. Gary Gorton, 1986. "Banking panics and business cycles," Working Papers 86-9, Federal Reserve Bank of Philadelphia.
  3. Goodfriend, M. & King, R.G., 1988. "Financial Deregulation, Monetary Policy, And Central Banking," RCER Working Papers 121, University of Rochester - Center for Economic Research (RCER).
  4. Seppo Honkapohja & Kaushik Mitra, . "Are Non-Fundamental Equilibria Learnable in Models of Monetary Policy?," Discussion Papers 01/05, Department of Economics, University of York.
  5. Christopher Kent & Guy Debelle, 1999. "Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy," RBA Research Discussion Papers rdp1999-05, Reserve Bank of Australia.
  6. Christopher Kent & Philip Lowe, 1997. "Asset-price Bubbles and Monetary Policy," RBA Research Discussion Papers rdp9709, Reserve Bank of Australia.
  7. Bennett T. McCallum, 1994. "Monetary Policy Rules and Financial Stability," NBER Working Papers 4692, National Bureau of Economic Research, Inc.
  8. Timothy Cogley, 1999. "Should the Fed take deliberate steps to deflate asset price bubbles?," Economic Review, Federal Reserve Bank of San Francisco, pages 42-52.
  9. Smets, Frank, 1997. "Financial Asset Prices and Monetary Policy: Theory and Evidence," CEPR Discussion Papers 1751, C.E.P.R. Discussion Papers.
  10. George G. Kaufman, 1998. "Central banks, asset bubbles, and financial stability," Working Paper Series WP-98-12, Federal Reserve Bank of Chicago.
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