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

_IMF Working Papers, September 1, 2011_

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## Bibliographic details
- Authors: Leonardo Luna, Dale F. Gray, Jorge Restrepo, Carlos Garcia
- Published: September 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781463921286.001

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### Summary and central question
- 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: whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function.
- Key empirical result: including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility.

### Findings on channels and conditions
- Including dtd in the reaction function:
  - Reduces inflation volatility.
  - Reduces output volatility.
- Results are robust across different model calibrations.
- Conditions where inclusion of dtd is more efficient:
  - Whenever exchange-rate pass-through is higher.
  - Whenever financial vulnerability has a larger impact on the exchange rate.
  - Whenever financial vulnerability has a larger impact on GDP.
  - In the reverse case (more effect of GDP on bank's equity, i.e., endogeneity), inclusion remains more efficient.

### Model elements and terminology
- Financial stability indicator used: distance-to-default (dtd) of the banking system.
- Integrated framework: a model of financial sector vulnerability coupled with a macroeconomic model typically used for monetary policy analysis.
- Concepts preserved from the source: exchange-rate pass-through, endogeneity (effect of GDP on bank's equity), reaction function, financial vulnerability.

### Policy implications and recommendations
- Monetary policy reaction functions can improve macroeconomic stability by explicitly incorporating financial sector risk measures such as dtd.
- Central banks facing higher exchange-rate pass-through or stronger links between financial vulnerability and real activity (or stronger endogeneity) will find it more efficient to include financial stability indicators in interest rate rules.

### Publication and metadata
- Authors: Leonardo Luna, Dale F. Gray, Jorge Restrepo, Carlos Garcia
- Date: September 1, 2011
- Series: IMF Working Papers
- Working Paper No.: 2011/228
- Issue: 228
- Volume: 2011
- Pages: 34
- DOI: https://doi.org/10.5089/9781463921286.001
- Stock No: WPIEA2011228
- ISBN: 9781463921286
- ISSN: 1018-5941
- Subject keywords: Asset and liability management; Asset valuation; Banking; Financial institutions; Financial sector policy and analysis; Financial sector risk; Inflation; Output gap; Prices; Production; Stocks
- Additional keywords: Asia and Pacific; asset valuation; asset volatility; bank assets; central banking; Financial sector risk; Financial vulnerability; Inflation; interest rate; monetary policy; monetary policy interest rate; Output gap; reaction function; risk indicator; Stocks; WP

*IMF Working Paper summary page for "Incorporating Financial Sector Risk Into Monetary Policy Models: Application to Chile" (authors: Leonardo Luna, Dale F. Gray, Jorge Restrepo, Carlos Garcia; September 1, 2011).*

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/incorporating-financial-sector-risk-into-monetary-policy-models-application-to-chile-25268_