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Monetary Policy Rules and Financial Stress: Does Financial Instability Matter for Monetary

  • Jaromír Baxa

    ()

    (Institute of Economic Studies, Charles University, Prague and Institute of Information Theory and Automation, Academy of Sciences of the Czech Republic)

  • Roman Horváth

    ()

    (Czech National Bank and Institute of Economic Studies, Charles University, Prague)

  • Borek Vasícek

    ()

    (Departament d'Economia Aplicada, Universitat Autonoma de Barcelona)

We examine whether and how main central banks responded to episodes of financial stress over the last three decades. We employ a new methodology for monetary policy rules estimation, which allows for time-varying response coefficients as well as corrects for endogeneity. This flexible framework applied to the U.S., U.K., Australia, Canada and Sweden together with a new financial stress dataset developed by the International Monetary Fund allows not only testing whether the central banks responded to financial stress but also detects the periods and type of stress that were the most worrying for monetary authorities and to quantify the intensity of policy response. Our findings suggest that central banks often change policy rates: mainly decreasing it in the face of high financial stress. However, the size of a policy response varies substantially over time as well as across countries, with the 2008-2009 financial crisis being the period of the most severe and generalized response. With regards to the specific components of financial stress, most central banks seemed to respond to stock market stress and bank stress, while exchange rate stress is found to drive the reaction of central banks only in more open economies.

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Paper provided by Department of Applied Economics at Universitat Autonoma of Barcelona in its series Working Papers with number wpdea1101.

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Length: 46 pages
Date of creation: Jan 2011
Date of revision:
Handle: RePEc:uab:wprdea:wpdea1101
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