Systemic Risk: A New Trade-off for Monetary Policy?

IMF Working Papers, June 30, 2015

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Introduces time-varying systemic risk in an otherwise standard New-Keynesian model.
Objective: study whether a simple leaning-against-the-wind policy can reduce systemic risk and improve welfare.

An unexpected increase in policy rates:
- reduces output,
- reduces inflation,
- reduces asset prices,
- does not fundamentally mitigate financial risks.
A systematic monetary policy reaction:
- can improve welfare,
- is highly sensitive to parameters of the model,
- is detrimental in the presence of falling asset prices.
Macroprudential policy, similar to a countercyclical capital requirement:
- is more robust,
- leads to higher welfare gains.

Leaning-against-the-wind monetary tightening is ineffective at fundamentally mitigating systemic financial risks and can harm macroeconomic outcomes.
Systematic monetary-policy rules are insufficient alone due to parameter sensitivity and adverse effects when asset prices fall.
Macroprudential tools (for example, countercyclical capital requirements) are preferred for robustness and greater welfare improvement.

Subject: Asset prices, Economic sectors, Financial institutions, Financial sector, Inflation, Nonbank financial institutions, Prices, Stocks
Keywords: Asset prices, deviations from fundamentals, DSGE models, Endogenous Financial Risk, equity constraint, equity constraint bind, Financial sector, Global, Inflation, inflation index, monetary policy, monetary policy behavior, monetary policy reaction, monetary policy shock, monetary policy surprise, Non-Linear Dynamics, Nonbank financial institutions, Policy Evaluation, price inflation index, prices-low return, Stocks, surprise monetary policy tightening, utility function, WP