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Financial Variables in a Policy Rule: Does It Bring Macroeconomic Benefits?

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  • Jan Zacek

    () (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nabrezi 6, 111 01 Prague 1, Czech Republic)

Abstract

After the recent financial crisis of 2007, a connection between monetary policy and financial stability has started to be thoroughly investigated. One of the particular areas of this research field deals with the role of various financial variables in the monetary policy rules. The main purpose of this research is to find whether direct incorporation of the financial variables in the monetary policy rule can bring macroeconomic benefits in terms of lower volatility of inflation and output. So far, the main emphasis of the research has been placed on the investigation of the augmented Taylor rules in the context of a closed economy. This paper sheds light on the performance of the augmented Taylor rules in a small open economy. For this purpose, a New Keynesian DSGE model with two types of financial frictions is constructed. The model is calibrated for the Czech Republic. This work provides four conclusions. First, incorporation of the financial variables (asset prices and the volume of credit) in the monetary policy rule is beneficial for macroeconomic stabilization in terms of lower implied volatilities of inflation and output. Second, the usefulness of the augmented monetary policy rule is the most apparent in case of the shock originating abroad. Third, there is a strong link between the financial and the real side of an economy. Fourth, if the banking sector experiences a sharp drop in bank capital that brings this sector into decline, activity in the whole economy deteriorates and monetary policy is not able to achieve macroeconomic stability using its conventional tools.

Suggested Citation

  • Jan Zacek, 2016. "Financial Variables in a Policy Rule: Does It Bring Macroeconomic Benefits?," Working Papers IES 2016/25, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Dec 2016.
  • Handle: RePEc:fau:wpaper:wp2016_25
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    File URL: http://ies.fsv.cuni.cz/sci/publication/show/id/5587/lang/cs
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    References listed on IDEAS

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    More about this item

    Keywords

    DSGE models; financial imperfections; inflation targeting; monetary policy;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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