Monetary Policy and Financial Conditions: A Cross-Country Study

Abstract

Loose financiall conditions forecast high output growth and low output volatility up to six quarters into the future, generating time varying downside risk to the output gap which we measure by GDP-at-Risk (GaR). This finding is robust across countries, conditioning variables, and time periods. We study the implications for monetary policy in a reduced form New Keynesian model with financial intermediaries that are subject to a Value at Risk (VaR) constraint. Optimal monetary policy depends on the magnitude downside risk to GDP, as it impacts the consumption-savings decision via the Euler constraint, and the financial conditions via the tightness of the VaR constraint. The optimal monetary policy rule exhibits a pronounced response to shifts in financial conditions for most countries in our sample. Welfare gains from taking financial conditions into account are shown to be sizable.

Keywords: financial conditions, Financial Stability, monetary policy

JEL Classification: E52