Incorporating Financial Sector Risk Into Monetary Policy Models : Application to Chile

Author/Editor: Leonardo Luna ; Dale F. Gray ; Jorge Restrepo ; Carlos Garcia
Publication Date: September 01, 2011
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate
Summary: This paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. The main question to be answered with the integrated model is whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. It is found in general, that including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility. Moreover, the results are robust to different model calibrations: whenever exchange-rate pass-through is higher; financial vulnerability has a larger impact on the exchange rate, as well as on GDP (or the reverse, there is more effect of GDP on bank''s equity - i.e., what we call endogeneity), it is more efficient to include dtd in the reaction function.
Series: Working Paper No. 11/228
Subject(s): Banking systems | Economic models | Financial risk | Financial sector

Author's Keyword(s): Financial vulnerability | monetary policy | central banking
Publication Date: September 01, 2011
ISBN/ISSN: 9781463921286/1018-5941 Format: Paper
Stock No: WPIEA2011228 Pages: 34
US$18.00 (Academic Rate:
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