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Financial vulnerability and monetary policy

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  • Fernando M. Duarte
  • Tobias Adrian

Abstract

We present a microfounded New Keynesian model that features financial vulnerabilities. Financial intermediaries' occasionally binding value-at-risk constraints give rise to variation in the pricing of risk that generates time-varying risk in the conditional mean and volatility of the output gap. The conditional mean and volatility are negatively related: during times of easy financial conditions, growth tends to be high, and risk tends to be low. Monetary policy affects output directly through the investment-savings curve, and indirectly through the pricing of risk that relates to the tightness of the value-at-risk constraint. The optimal monetary policy rule always depends on financial vulnerabilities in addition to the output gap, inflation, and the natural rate of interest. We show that a classic Taylor rule exacerbates deviations of the output gap from its target value of zero relative to an optimal interest rate rule that includes vulnerability. Simulations show that optimal policy significantly increases welfare relative to a classic Taylor rule. Alternative policy paths using historical examples illustrate the usefulness of the proposed policy rule.

Suggested Citation

  • Fernando M. Duarte & Tobias Adrian, 2016. "Financial vulnerability and monetary policy," Staff Reports 804, Federal Reserve Bank of New York, revised 01 Feb 2017.
  • Handle: RePEc:fip:fednsr:804
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    References listed on IDEAS

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    1. repec:oup:qjecon:v:132:y:2017:i:3:p:1373-1426. is not listed on IDEAS
    2. Borio, Claudio & Zhu, Haibin, 2012. "Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?," Journal of Financial Stability, Elsevier, vol. 8(4), pages 236-251.
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    5. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361, National Bureau of Economic Research, Inc.
    6. Fernando M. Duarte, 2016. "How to escape a liquidity trap with interest rate rules," Staff Reports 776, Federal Reserve Bank of New York, revised 01 Dec 2016.
    7. Janet L. Yellen, 2016. "The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future : a speech at \\"Designing Resilient Monetary Policy Frameworks for the Future,\\" a symposium sponsored by the Feder," Speech 906, Board of Governors of the Federal Reserve System (U.S.).
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    Citations

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    Cited by:

    1. Andrew Filardo & Marco Jacopo Lombardi & Marek Raczko, 2018. "Measuring financial cycle time," BIS Working Papers 755, Bank for International Settlements.
    2. repec:bis:bisbps:95 is not listed on IDEAS
    3. repec:wly:iecrev:v:60:y:2019:i:2:p:939-963 is not listed on IDEAS
    4. repec:wly:jmoncb:v:51:y:2019:i:5:p:1309-1353 is not listed on IDEAS
    5. Jinill Kim & Francisco Ruge‐Murcia, 2019. "Extreme Events And Optimal Monetary Policy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 60(2), pages 939-963, May.
    6. Kyungsoo Kim & Byoung-Ki Kim & Hail Park, 2011. "Monetary policy framework and financial procyclicality: international evidence," BIS Papers chapters, in: Bank for International Settlements (ed.), Macroprudential regulation and policy, volume 60, pages 51-57, Bank for International Settlements.
    7. Stephen S. Poloz, 2019. "Technological Progress and Monetary Policy: Managing the Fourth Industrial Revolution," Discussion Papers 2019-11, Bank of Canada.
    8. Michael T. Kiley, 2018. "Unemployment Risk," Finance and Economics Discussion Series 2018-067, Board of Governors of the Federal Reserve System (US), revised 28 Sep 2018.
    9. Adrian, Tobias & Grinberg, Federico & Liang, Nellie & Malik, Sheherya, 2018. "The Term Structure of Growth-at-Risk," CEPR Discussion Papers 13349, C.E.P.R. Discussion Papers.
    10. Van der Ghote, Alejandro, 2018. "Coordinating monetary and financial regulatory policies," Working Paper Series 2155, European Central Bank.
    11. Adrian, Tobias & Duarte, Fernando & Grinberg, Federico & Mancini-Griffoli, Tommaso, 2018. "Monetary Policy and Financial Conditions: A Cross-Country Study," CEPR Discussion Papers 12681, C.E.P.R. Discussion Papers.
    12. William Chen & Gregory Phelan, 2018. "Dynamic Consequences of Monetary Policy for Financial Stability," Department of Economics Working Papers 2018-06, Department of Economics, Williams College.
    13. Zorobabel Bicaba & Daniel Kapp & Francesco Molteni, 2011. "Stability periods between financial crises : The role of macroeconomic fundamentals and crises management policies," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00639869, HAL.
    14. Bicaba, Zorobabel & Kapp, Daniel & Molteni, Francesco, 2014. "Stability periods between financial crises: The role of macroeconomic fundamentals and crises management policies," Economic Modelling, Elsevier, vol. 43(C), pages 346-360.
    15. Bruno Albuquerque, 2019. "One Size Fits All? Monetary Policy and Asymmetric Household Debt Cycles in U.S. States," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 51(5), pages 1309-1353, August.
    16. Claudio Borio & Piti Disyatat & Phurichai Rungcharoenkitkul, 2018. "What anchors for the natural rate of interest?," PIER Discussion Papers 98, Puey Ungphakorn Institute for Economic Research, revised Nov 2018.
    17. Isabel Cairo & Jae Sim, 2017. "Income Inequality, Financial Crises and Monetary Policy," 2017 Meeting Papers 1433, Society for Economic Dynamics.

    More about this item

    Keywords

    macro-finance; monetary policy; financial stability;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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