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Evaluating monetary policy with financial stability objective: rules vs. discretion

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  • Menelik Geremew

Abstract

This article explores whether adding the goal of financial stability to the more traditional goals of output and price stability could improve optimality of monetary policy. A Dynamic Stochastic General Equilibrium model that endogenously incorporates financial frictions is used to derive optimality conditions across rule-based and discretionary monetary policy environments. The results indicate that it is optimal for the Central Bank to keep output below the potential level in the short term so as to dampen the inflationary effects arising from supply and financial shocks. When the economy is exposed to a financial shock, both leverage and credit spread rise significantly, thereby tipping the economy into a financial crisis and raising the probability of macroeconomic risk.

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  • Menelik Geremew, 2017. "Evaluating monetary policy with financial stability objective: rules vs. discretion," Applied Economics Letters, Taylor & Francis Journals, vol. 24(9), pages 602-617, May.
    • Handle: RePEc:taf:apeclt:v:24:y:2017:i:9:p:602-617
    DOI: 10.1080/13504851.2016.1217299
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    1. Vasco Curdia, 2008. "Optimal monetary policy under sudden stops," Staff Reports 323, Federal Reserve Bank of New York.
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