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Optimal monetary policy with the risk-taking channel

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  • Abbate, Angela
  • Thaler, Dominik

Abstract

Empirical research suggests that lower interest rates induce banks to take higher risks. We assess analytically what this risk-taking channel implies for optimal monetary policy in a tractable New Keynesian model. We show that this channel creates a motive for the planner to stabilize the real rate. This objective conflicts with the standard inflation stabilization objective. Optimal policy thus tolerates more inflation volatility. An inertial Taylor-type reaction function becomes optimal. We then quantify the significance of the risk-taking channel for monetary policy in an estimated medium-scale extension of the model. Ignoring the channel when designing policy entails non-negligible welfare costs (0.7%lifetime consumption equivalent). JEL Classification: E44, E52

Suggested Citation

  • Abbate, Angela & Thaler, Dominik, 2023. "Optimal monetary policy with the risk-taking channel," Working Paper Series 2772, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20232772
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    References listed on IDEAS

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    1. Optimal monetary policy with the risk-taking channel
      by Christian Zimmermann in NEP-DGE blog on 2021-04-29 16:32:18

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    More about this item

    Keywords

    inertial policy rate; optimal monetary policy; risk-taking channel;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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