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Incorporating Financial Sector Risk Into Monetary Policy Models; Application to Chile

Author

Listed:
  • Leonardo Luna
  • Dale F. Gray
  • Jorge Restrepo
  • Carlos Garcia

Abstract

This paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. The main question to be answered with the integrated model is whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. It is found in general, that including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility. Moreover, the results are robust to different model calibrations: whenever exchange-rate pass-through is higher; financial vulnerability has a larger impact on the exchange rate, as well as on GDP (or the reverse, there is more effect of GDP on bank's equity - i.e., what we call endogeneity), it is more efficient to include dtd in the reaction function.

Suggested Citation

  • Leonardo Luna & Dale F. Gray & Jorge Restrepo & Carlos Garcia, 2011. "Incorporating Financial Sector Risk Into Monetary Policy Models; Application to Chile," IMF Working Papers 11/228, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:11/228
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    References listed on IDEAS

    as
    1. Cúrdia, Vasco & Woodford, Michael, 2016. "Credit Frictions and Optimal Monetary Policy," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 30-65.
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    3. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
    4. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
    5. Papa M N'Diaye, 2009. "Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy," IMF Working Papers 09/257, International Monetary Fund.
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    1. repec:jes:wpaper:y:2013:v:5:p:535-547 is not listed on IDEAS
    2. Renata Karkowska, 2013. "Instability In The Cee Banking System. Evidence From The Recent Financial Crisis," CES Working Papers, Centre for European Studies, Alexandru Ioan Cuza University, vol. 5(4), pages 535-547, December.
    3. Francis Leni Anguyo & Rangan Gupta & Kevin Kotze, 2017. "Monetary Policy and Financial Frictions in a Small Open-Economy Model for Uganda," School of Economics Macroeconomic Discussion Paper Series 2017-01, School of Economics, University of Cape Town.
    4. Karkowska, Renata, 2014. "Is the Central and Eastern European banking systems stable? Evidence from the recent financial crisis," MPRA Paper 58803, University Library of Munich, Germany.
    5. Burcu Aydin & Myeongsuk Kim & Ho-Seong Moon, 2011. "Financial Linkages Across Korean Banks," IMF Working Papers 11/201, International Monetary Fund.

    More about this item

    Keywords

    Chile; Central banking; Monetary policy; Fiscal policy; Financial vulnerability; inflation; banking; central bank; banking system; Open Economy Macroeconomics;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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