Incorporating Financial Sector Risk into Monetary Policy Models: Application to Chile

35 Pages Posted: 8 Oct 2011

See all articles by Dale F. Gray

Dale F. Gray

International Monetary Fund (IMF); MF Risk

Carlos J. Garcia

Universidad Alberto Hurtado

Leonardo Luna

University of Santiago, Chile

Jorge Restrepo

International Monetary Fund (IMF)

Date Written: September 2011

Abstract

This paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. The main question to be answered with the integrated model is whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. It is found in general, that including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility. Moreover, the results are robust to different model calibrations: whenever exchange-rate pass-through is higher; financial vulnerability has a larger impact on the exchange rate, as well as on GDP (or the reverse, there is more effect of GDP on bank’s equity - i.e., what we call endogeneity), it is more efficient to include dtd in the reaction function.

Suggested Citation

Gray, Dale F. and Garcia, Carlos J. and Luna, Leonardo and Restrepo, Jorge, Incorporating Financial Sector Risk into Monetary Policy Models: Application to Chile (September 2011). IMF Working Papers, Vol. , pp. 1-34, 2011. Available at SSRN: https://ssrn.com/abstract=1940814

Dale F. Gray

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

MF Risk

5921 Searl Terrace
Bethesda, MD 20816

Carlos J. Garcia

Universidad Alberto Hurtado ( email )

Erasmo Escala 1835
Santiago 6500620
Chile

Leonardo Luna

University of Santiago, Chile ( email )

Santiago
Chile

Jorge Restrepo

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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