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Price Versus Financial Stability: A role for money in Taylor rules?

  • John Keating

    (Department of Economics, The University of Kansas)

  • Andrew Lee Smith

    (Department of Economics, The University of Kansas)

This paper analyzes optimal monetary policy in a standard New-Keynesian model augmented with a financial sector. The banks in the model are subject to shocks which impede their ability and willingness to produce financial assets. We show these financial market supply shocks decrease both the natural rates of output and interest. The implication is that an optimizing central bank with real time data on only inflation, output, interest rate spreads and monetary aggregates will respond positively to the growth rate of monetary aggregates which signal movement in the natural rate from these financial shocks. This simple rule is implementable by central banks as it makes the policy instrument a function of only observables and does not require precise knowledge of the model or the parameters. The key is the use of the Divisia monetary aggregate which provides a parameter- and estimation- free approximation to the the true monetary aggregate. We show policy rules reacting to the Divisia monetary aggregate have well-behaved determinacy properties - satisfying a novel Taylor principle for monetary aggregates. Finally, we conclude with a minimax robust policy prescription given the uncertainty surrounding parameters driving the financial and other structural shocks.

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File URL: http://www2.ku.edu/~kuwpaper/2013Papers/201307.pdf
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Paper provided by University of Kansas, Department of Economics in its series WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS with number 201307.

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Length: 31 pages
Date of creation: Oct 2013
Date of revision:
Handle: RePEc:kan:wpaper:201307
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  1. William Poole, 1969. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Special Studies Papers 2, Board of Governors of the Federal Reserve System (U.S.).
  2. Belongia, Michael T, 1996. "Measurement Matters: Recent Results from Monetary Economics Reexamined," Journal of Political Economy, University of Chicago Press, vol. 104(5), pages 1065-83, October.
  3. William A Barnett & Marcelle Chauvet, 2011. "Financial Aggregation And Index Number Theory," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., volume 2, number 7580.
  4. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," CEPR Discussion Papers 2963, C.E.P.R. Discussion Papers.
  5. Dellas, H. & Diba, B. & Loisel, O., 2010. "Financial Shocks and Optimal Policy," Working papers 277, Banque de France.
  6. Gali, Jordi & Lopez-Salido, J. David & Valles, Javier, 2003. "Technology shocks and monetary policy: assessing the Fed's performance," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 723-743, May.
  7. Faia, Ester & Monacelli, Tommaso, 2007. "Optimal interest rate rules, asset prices, and credit frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3228-3254, October.
  8. William Barnett & Apostolos Serletis & W. Erwin Diewert, 2005. "The Theory of Monetary Aggregation (book front matter)," Macroeconomics 0511008, EconWPA.
  9. Javier Andrés & David López-Salido & Edward Nelson, 2008. "Money and the natural rate of interest: structural estimates for the United States and the euro area," Banco de Espa�a Working Papers 0805, Banco de Espa�a.
  10. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1105-1129, September.
  11. Barnett, William A., 1978. "The user cost of money," Economics Letters, Elsevier, vol. 1(2), pages 145-149.
  12. Diewert, W. E., 1976. "Exact and superlative index numbers," Journal of Econometrics, Elsevier, vol. 4(2), pages 115-145, May.
  13. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
  14. Helge Berger & Henning Weber, 2012. "Money As Indicator for the Natural Rate of Interest," IMF Working Papers 12/6, International Monetary Fund.
  15. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
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