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Monetary policy rules with financial instability

Sofia Bauducco, Aleš Bulíř, Martin Čihák

To provide a rigorous analysis of monetary policy in the face of financial instability, we extend the standard dynamic stochastic general equilibrium model to include a financial system. Our simulations suggest that if financial instability affects output and inflation with a lag, and if the central bank has privileged information about credit risk, monetary policy responding instantly to increased credit risk can trade off more output and inflation instability today for a faster return to the trend than a policy that follows the simple Taylor rule. This augmented rule leads in some parameterizations to improved outcomes in terms of long-term welfare, however, the welfare impacts of such a rule appear to be negligible.

JEL Codes: E52, E58, G21.

Keywords: DSGE models, financial instability, monetary policy rule.

Issued: December 2008

Download: CNB WP No. 8/2008 (pdf, 931 kB)

Published as: Bauducco, S., Bulíř, A., Čihák, M. (2011): Monetary Policy Rules with Financial Instability. Czech Journal of Economics and Finance, 61(6), 545–565