Monetary Policy and Financial Stability in the Long Run

44 Pages Posted: 12 Nov 2013

See all articles by Jin Cao

Jin Cao

Norges Bank - Research Department; Ludwig Maximilian University of Munich (LMU); CESifo (Center for Economic Studies and Ifo Institute)

Lorán Chollete

UiS Business School

Date Written: August 22, 2013

Abstract

Most theoretical central bank models use short horizons and focus on a single tradeoff. However, in reality, central banks play complex, long-horizon games and face more than one tradeoff. We account for these issues in a simple infinite-horizon game with a novel tradeoff: higher rates deter financial imbalances, but lower rates reduce the likelihood of insolvency. We term these factors discipline and stability effects, respectively. The central bank's welfare decreases with dependence between real and financial shocks, so it may reduce costs with correlation-indexed securities. In our model, independent central banks cannot in general attain both low inflation and financial stability.

Keywords: Central Bank, Correlation-Indexed Security, Discipline Effect, Stability Effect

JEL Classification: E500, G210, G280

Suggested Citation

Cao, Jin and Chollete, Loran, Monetary Policy and Financial Stability in the Long Run (August 22, 2013). Norges Bank Working Paper 21, Available at SSRN: https://ssrn.com/abstract=2352999 or http://dx.doi.org/10.2139/ssrn.2352999

Jin Cao (Contact Author)

Norges Bank - Research Department ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Ludwig Maximilian University of Munich (LMU) ( email )

Bankplassen 2, PB 1179 Sentrum
Oslo, NO-0107
Norway

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Loran Chollete

UiS Business School ( email )

PB 8002
Stavanger, 4036
Norway

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