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Bank of Finland Research Discussion Papers, Bank of Finland

No 21/2014:
Financial shocks and optimal monetary policy rules

Fabio Verona (), Manuel M. F. Martins () and Inęs Drumond ()

Abstract: We assess the performance of optimal Taylor-type interest rate rules, with and without reaction to financial variables, in stabilizing the macroeconomy following financial shocks. We use a DSGE model that comprises both a loan and a bond market, which best suits the contemporary structure of the U.S. financial system and allows for a wide set of financial shocks and transmission mechanisms. Overall, we find that targeting financial stability – in particular credit growth, but in some cases also financial spreads and asset prices – improves macroeconomic stabilization. The specific policy implications depend on the policy regime, and on the origin and the persistence of the financial shock.

Keywords: financial shocks; optimal monetary policy; Taylor rules; DSGE models; bond market; loan market; (follow links to similar papers)

JEL-Codes: E32; E44; E52; (follow links to similar papers)

49 pages, July 25, 2014

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