Monetary Policy and Financial Stability

Abstract

How should monetary policy respond to deteriorating financial conditions? We develop and estimate a dynamic new Keynesian model with financial intermediaries and sticky long-term corporate leverage to show that active response to movements in credit conditions helps to mitigate losses in aggregate consumption and output associated with macro fluctuations. A (credible) monetary policy rule that includes credit spreads is thus welfare-improving, sometimes even obviating the need for explicit inflation targeting.

Keywords: Credit spreads, monetary policy rules, financial stability

JEL Classification: E12, E43, E44, E52, G32