Financial Shocks, Financial Stability, and Optimal Taylor Rules

50 Pages Posted: 22 May 2017  

Fabio Verona

Bank of Finland - Research

Manuel V. Martins

Universidade do Porto

Inês Drumond

Universidade do Porto - Faculdade de Economia (FEP)

Date Written: August 26, 2014

Abstract

We assess the performance of optimal Taylor-type interest rate rules, with and without reaction to financial variables, in stabilizing an economy following financial shocks. The analysis is conducted in a DSGE model with loan and bond markets, each featuring financial frictions. This allows for a wide set of financial shocks and transmission mechanisms and can be calibrated to match the bond-to-bank finance ratio featured in the US financial system. Overall, we find that monetary policy that reacts to credit growth, a form of the so-called “leaning against the wind”, improves the ability of the central bank to achieve its mandate in the wake of financial shocks. The specific policy implications depend partly on the origin and the persistence of the financial shock, but overall not on the assignment of a mandate for financial stability in the central bank’s objective function. Keywords: financial shocks, optimal monetary policy, Taylor rules, DSGE models, bond market, loan market JEL codes: E32, E44, E52

Suggested Citation

Verona, Fabio and Martins, Manuel V. and Drumond, Inês, Financial Shocks, Financial Stability, and Optimal Taylor Rules (August 26, 2014). Bank of Finland Research Discussion Paper No. 21/2014. Available at SSRN: https://ssrn.com/abstract=2971395

Manuel V. Martins

Universidade do Porto ( email )

Inês Drumond

Universidade do Porto - Faculdade de Economia (FEP) ( email )

Porto
Portugal

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