Financial Vulnerability and Monetary Policy

67 Pages Posted: 30 Dec 2016 Last revised: 6 Sep 2017

See all articles by Tobias Adrian

Tobias Adrian

International Monetary Fund

Fernando Duarte

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: 2016-12-01

Abstract

We present a microfounded New Keynesian model that features financial vulnerabilities. Financial intermediaries' occasionally binding value-at-risk constraints give rise to variation in the pricing of risk that generates time-varying risk in the conditional mean and volatility of the output gap. The conditional mean and volatility are negatively related: during times of easy financial conditions, growth tends to be high, and risk tends to be low. Monetary policy affects output directly through the investment-savings curve, and indirectly through the pricing of risk that relates to the tightness of the value-at-risk constraint. The optimal monetary policy rule always depends on financial vulnerabilities in addition to the output gap, inflation, and the natural rate of interest. 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. Simulations show that optimal policy significantly increases welfare relative to a classic Taylor rule. Alternative policy paths using historical examples illustrate the usefulness of the proposed policy rule.

Keywords: monetary policy, macro-finance, financial stability

JEL Classification: E52, G10, G12

Suggested Citation

Adrian, Tobias and Duarte, Fernando, Financial Vulnerability and Monetary Policy (2016-12-01). FRB of NY Staff Report No. 804. Available at SSRN: https://ssrn.com/abstract=2891253

Tobias Adrian (Contact Author)

International Monetary Fund ( email )

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

HOME PAGE: http://www.tobiasadrian.com

Fernando Duarte

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

HOME PAGE: http://www.newyorkfed.org/research/economists/duarte/index.html

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