Taylor Rule Under Financial Instability

IMF Working Papers, January 1, 2008

Source details

Authors: Martin Cihak, Sofía Bauducco
Date: January 1, 2008
Series: Working Paper No. 2008/018
Issue: 018; Volume: 2008; Pages: 41
DOI: https://doi.org/10.5089/9781451868807.001
Subjects: Banking, Central bank policy rate, Financial sector, Loans, Technology
Keywords: financial system, goods firm, monetary policy, output gap, WP

Extends the standard new Keynesian dynamic stochastic general equilibrium (DSGE) model with sticky prices to include a financial system.
Simulations are used to assess monetary-policy responses under financial instability.
Key informational assumption: the central bank may have privileged information about credit risk.

If financial instability affects output and inflation with a lag, and the central bank has privileged information about credit risk, then:
- Monetary policy that responds 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 with only the contemporaneous output gap and inflation.
The paper's simulations indicate that incorporating credit-risk information into policy responses can improve the speed of recovery to trend relative to a contemporaneous-output-gap-and-inflation-only Taylor rule.

Monetary-policy rules that incorporate indicators of financial stress or credit risk (including timely or privileged measures) can be preferable to simple Taylor-type rules that condition only on contemporaneous output gap and inflation when financial instability is present.
Accepting higher short-run output and inflation variability may be warranted if it delivers a faster return to trend output and inflation in the presence of financial shocks that operate with lags.

Source: Taylor Rule Under Financial Instability, IMF Working Papers (Working Paper No. 2008/018).