Financial Vulnerability and Monetary Policy

Abstract

We present a microfounded New Keynesian model that features financial vulnerability. Financial intermediaries' occasionally binding value at risk constraints give rise to variation in the pricing of risk that generates time varying conditional moments of output. The conditional mean and volatility of the output gap are negatively related: during times of easy financial conditions---when the price of risk is low---growth tends to be high, and risk tends to be low. Monetary policy affects output directly via the intertemporal substitution of savings, and also via the pricing of risk that relates to the tightness of the value at risk constraints. The optimal monetary policy rule always depends on financial vulnerability in addition to the output gap, inflation, and the natural rate. We show that a classic Taylor rule exacerbates deviations of the output gap from its target value of zero relative to an optimal interest rate rule that includes vulnerability. The model provides a microfoundation for optimal monetary policy that takes financial vulnerability into account.

Keywords: monetary policy, macro-finance, financial stability

JEL Classification: E52, G10, G12