The Taylor Rule and Financial Stability: A Literature Review with Application for the Eurozone

The question of whether central banks should bear responsibility for financial stability is still unan-swered. Regarding interest rate implementation, it is thus not clear if and how the Taylor rule should be augmented by an additional financial stability term. This paper reviews the normative and positive literature on Taylor rules augmented with exchange rates, asset prices, credit, and spreads. These measures have developed as common indicators of financial (in)stability in the Taylor rule literature. In addition, our own analysis describes the development of these indicators for the core and the periphery of the Eurozone. Given the large degree of heterogeneity between euro area countries, the conclusion here is that an interest rate reaction to instability by the European Central Bank would be inappropriate in times of crisis. However, this conclusion is somewhat weakened if there is no crisis.