Monetary Policy and Financial Stability

Abstract

How should monetary policy respond to evolving financial conditions? To answer this question we develop and Bayesian estimate a dynamic macro model with a detailed financial sector and long-term defaultable nominal debt contracts to quantify how monetary policy response to movements in credit conditions can mitigate losses in aggregate consumption and output associated with macro fluctuations. We show that a (credible) monetary policy rule that includes credit spreads is often welfare-improving and generally obviates the need for explicit inflation targeting.

Keywords: Credit spreads, monetary policy rules, financial stability

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