Scandinavian Working Papers in Economics

Working Paper Series,
Sveriges Riksbank (Central Bank of Sweden)

No 341: Systemic Risk: A New Trade-Off for Monetary Policy?

Stefan Laséen (), Andrea Pescatori () and Jarkko Turunen ()
Additional contact information
Stefan Laséen: Monetary Policy Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Andrea Pescatori: International Monetary Fund, Postal: 700 19th Street, N.W., Washington, D.C. 20431, USA.
Jarkko Turunen: International Monetary Fund, Postal: 700 19th Street, N.W., Washington, D.C. 20431, USA.

Abstract: We introduce time-varying systemic risk (à la He and Krishnamurthy, 2014) in an otherwise standard New-Keynesian model to study whether simple leaning-against-the-wind interest rate rules can reduce systemic risk and improve welfare. We find that while financial sector leverage contains additional information about the state of the economy that is not captured in inflation and output leaning against financial variables can only marginally improve welfare because rules are detrimental in the presence of falling asset prices. An optimal macroprudential policy, similar to a countercyclical capital requirement, can eliminate systemic risk raising welfare by about 1.5%. Also, a surprise monetary policy tightening does not necessarily reduce systemic risk, especially during bad times. Finally, a volatility paradox a la Brunnermeier and Sannikov (2014) arises when monetary policy tries to excessively stabilize output.

Keywords: Monetary Policy; Endogenous Financial Risk; DSGE models; Non-Linear Dynamics; Policy Evaluation

JEL-codes: E30; E44; E52; E58; E61; G12; G20

53 pages, August 1, 2017

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