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Staff Reports
Financial Vulnerability and Monetary Policy
December 2016 Number 804
Revised November 2020
Revised November 2020
JEL classification: G10, G12, E52
We present a microfounded New Keynesian model that features financial vulnerabilities. Financial intermediaries’ occasionally binding value at risk constraints give rise to variation in the pricing of risk that generates time varying risk in the conditional mean and volatility of the output gap. The conditional mean and volatility of the output gap are negatively related: during times of easy financial conditions, growth tends to be high, and risk tends to be low. Monetary policy affects output directly via the IS curve, and indirectly via the pricing of risk that relates to the tightness of the value at risk constraints. The optimal monetary policy rule always depends on financial vulnerabilities in addition to the output gap, inflation, and the natural rate. We show that a classic Taylor rule exacerbates deviations of the output gap from its target value of zero relative to an optimal interest rate rule that includes vulnerability. Simulations show that optimal policy significantly increases welfare relative to a classic Taylor rule. The model provides a microfoundation for optimal monetary policy frameworks that take into account financial stability.
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