Financial Factors and Monetary Policy: Determinacy and Learnability of Equilibrium

59 Pages Posted: 3 Jul 2016

See all articles by Paul Kitney

Paul Kitney

Centre for Applied Macroeconomic Analysis

Date Written: July 1, 2016

Abstract

This paper contributes to the debate whether central banks should respond to asset prices, credit spreads and other financial factors in setting monetary policy, by evaluating determinacy and expectational stability of equilibria under various monetary policy rules. With adaptive learning, beliefs constitute an additional set of state variables, which may require more than a response to inflation, that has traditionally been argued in the literature as sufficient to achieve central bank objectives under rational expectations. Furthermore, financial frictions are introduced by extending the determinacy and adaptive learning methodology embodied in Bullard and Mitra (2002) and Bullard and Mitra (2007), beyond the New Keynesian modelling framework by incorporating a Financial Accelerator (Bernanke, Gertler and Gilchrist 1999). A key result is that monetary policy rules responding to lagged asset prices and credit volume have less desirable determinacy and learnability characteristics than responding to current asset prices and credit spreads. This conclusion dovetails with recent research such as Gilchrist and Zakrajsek (2011) and Gilchrist and Zakrajsek (2012), who show that signals derived from credit spreads contain information which help explain business cycle fluctuations and demonstrate that a credit spread augmented monetary policy rule dampens cycle variability. Another result is that the conclusions in both Bullard and Mitra (2002) and Bullard and Mitra (2007) are robust to a New Keynesian model with financial frictions.

Keywords: DSGE, financial frictions, learning, determinacy, e-stability, expectations, asset prices, credit spreads, financial factors, monetary policy, Taylor rule

JEL Classification: E43, E44, E50, E52, E58

Suggested Citation

Kitney, Paul, Financial Factors and Monetary Policy: Determinacy and Learnability of Equilibrium (July 1, 2016). CAMA Working Paper No. 41/2016 . Available at SSRN: https://ssrn.com/abstract=2802947 or http://dx.doi.org/10.2139/ssrn.2802947

Paul Kitney (Contact Author)

Centre for Applied Macroeconomic Analysis ( email )

ANU College of Asia and the Pacific
Crawford School of Public Policy
Canberra, Australian Capital Territory 2601
Australia

HOME PAGE: http://https://cama.crawford.anu.edu.au/

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