Financial Stability and Optimal Interest-Rate Policy

72 Pages Posted: 19 Aug 2016 Last revised: 21 Sep 2016

See all articles by Andrea Ajello

Andrea Ajello

Board of Governors of the Federal Reserve System

Thomas Laubach

Board of Governors of the Federal Reserve System

David Lopez-Salido

Board of Governors of the Federal Reserve System

Taisuke Nakata

Board of Governors of the Federal Reserve System

Date Written: August, 2016

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.

JEL Classification: E43, E52, E58, G01

Suggested Citation

Ajello, Andrea and Laubach, Thomas and Lopez-Salido, David and Nakata, Taisuke, Financial Stability and Optimal Interest-Rate Policy (August, 2016). FEDS Working Paper No. 2016-67, Available at SSRN: https://ssrn.com/abstract=2826404 or http://dx.doi.org/10.17016/FEDS.2016.067

Andrea Ajello (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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Thomas Laubach

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2715 (Phone)
202-452-3819 (Fax)

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Taisuke Nakata

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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