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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. Christopher Kent & Philip Lowe, 1997. "Asset-price Bubbles and Monetary Policy," RBA Research Discussion Papers rdp9709, Reserve Bank of Australia.
  2. 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.
  3. Honkapohja, Seppo & Mitra, Kaushik, 2001. "Are Non-Fundamental Equilibria Learnable in Models of Monetary Policy?," CEPR Discussion Papers 2846, C.E.P.R. Discussion Papers.
  4. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Economic Review, Federal Reserve Bank of Richmond, issue May, pages 3-22.
  5. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.
  6. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers 11-90, Wharton School Rodney L. White Center for Financial Research.
  7. Frank Smets, 1997. "Financial asset prices and monetary policy: theory and evidence," BIS Working Papers 47, Bank for International Settlements.
  8. George G. Kaufman, 1998. "Central banks, asset bubbles, and financial stability," Working Paper Series WP-98-12, Federal Reserve Bank of Chicago.
  9. 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.
  10. Bennett T. McCallum, 1994. "Monetary Policy Rules and Financial Stability," NBER Working Papers 4692, National Bureau of Economic Research, Inc.
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