Risks to Financial Stability and Monetary Policy: Rules or Discretion? - Theoretical Economics Letters

TEL > Vol.7 No.4, June 2017

Risks to Financial Stability and Monetary Policy: Rules or Discretion? ()

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Download as PDF (Size: 503KB) PP. 1043-1065

DOI: 10.4236/tel.2017.74071 1,856 Downloads 3,415 Views Citations

Author(s)

Charles Richard Barrett¹, Ioanna T. Kokores^2*, Somnath Sen³

Affiliation(s)

¹Centre for Urban and Regional Studies, The University of Birmingham, Birmingham, UK.
²Department of Economics, The University of Piraeus, Piraeus, Greece.
³Department of Economics, The University of Birmingham, Birmingham, UK.

ABSTRACT

We evaluate monetary policy which is conducted in a way that addresses financial stability as an explicit monetary policy objective using a simple game theoretic model analysing the strategic interaction between a central bank and a financial sector. The extant literature in favour of “lean-against-the-wind” (LATW) monetary policy calls for more flexibility and the use of longer policy-horizons. We, therefore, assess monetary policy under discretion and under commitment to an instrument rule. Our analysis supports that rule-based LATW monetary policy outperforms the discretionary equivalent, in terms of controlling inflation, anchoring inflation expectations to the central bank’s inflation target and enhancing financial sector profitability. Under substantial risks to financial stability, we conclude that rule-based LATW monetary policy induces the financial sector to impose more prudence on its operation.

KEYWORDS

Monetary Policy, Central Bank, Financial Stability, Strategic Behaviour

Share and Cite:

Barrett, C. , Kokores, I. and Sen, S. (2017) Risks to Financial Stability and Monetary Policy: Rules or Discretion?. Theoretical Economics Letters, 7, 1043-1065. doi: 10.4236/tel.2017.74071.

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