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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Financial Stability and Optimal Interest-Rate Policy
Andrea Ajello
Thomas Laubach
J. David Lopez-Salido
Taisuke Nakata
Abstract

We study optimal interest-rate policy in a New Keynesian model in which the economy can experience financial crises and the probability of a crisis depends on credit conditions. The optimal adjustment to interest rates in response to credit conditions is (very) small in the model calibrated to match the historical relationship between credit conditions, output, inflation, and likelihood of financial crises. Given the imprecise estimates of key parameters, we also study optimal policy under parameter uncertainty. We find that Bayesian and robust central banks will respond more aggressively to financial instability when the probability and severity of financial crises are uncertain.


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Andrea Ajello & Thomas Laubach & J. David Lopez-Salido & Taisuke Nakata, Financial Stability and Optimal Interest-Rate Policy, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2016-067, Aug 2016.
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Keywords: Financial crises ; Financial stability and risk ; Leverage ; Monetary policy ; Optimal policy
DOI: 10.17016/FEDS.2016.067
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