Monetary Policy Rules with Financial Instability

Sofia Bauducco, Ales Bulir and Martin Cihák

presented at: Monetary Policy Rules with Financial Instability (08 Feb 2010)

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The presentation is based on a paper written with co-authors Sofia Bauducco and Martin Cihak. To provide a rigorous analysis of monetary policy in the face of financial instability, we extend the standard dynamic stochastic general equilibrium model to include a financial system. Our simulations suggest that if financial instability affects output and inflation with a lag, and if the central bank has privileged information about credit risk, monetary policy responding instantly to increased credit risk can trade off more output and inflation instability today for a faster return to the trend than a policy that follows the simple Taylor rule. This augmented rule leads in some parameterizations to improved outcomes in terms of long-term welfare, however, the welfare impacts of such a rule appear to be negligible.

Ales Bulir has been holding a research position at the IMF since 1993. Earlier he worked at the Czech National Bank. He was assistant and associate professor at the Prague University of Economics in 1987-1993 and 2002-2003. He is associate editor of the Czech Journal of Economics and Finance, member of the editorial board of Economic Systems, in 2001-2006 he was member of the External Research Committee of the Czech National Bank. His recent publications include 'The Dynamic Implications of Foreign Aid and its Variability', Journal of Development Economics, 2009 (co-authors: C. Arellano, T. Lane and L. Lipschitz); 'Volatility of Development Aid: From the Frying Pan into the Fire?', World Development, 2008 (co-author: A. Hamann); and 'Writing Clearly: ECB's Monetary Policy Communication', WP/08/252 (co-authors: M. Cihak and K. Smidkova).