TITLE:
Risks to Financial Stability and Monetary Policy: Rules or Discretion?
AUTHORS:
Charles Richard Barrett, Ioanna T. Kokores, Somnath Sen
KEYWORDS:
Monetary Policy, Central Bank, Financial Stability, Strategic Behaviour
JOURNAL NAME:
Theoretical Economics Letters,
Vol.7 No.4,
June
22,
2017
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.