Staff Reports
Financial Vulnerability and Monetary Policy
December 2016   Number 804
Revised March 2017
JEL classification: G10, G12, E52

Authors:   Tobias Adrian and Fernando Duarte

We present a microfounded New Keynesian model that features financial vulnerabilities. Financial intermediaries' occasionally binding value-at-risk constraints give rise to vulnerabilities that generate time-varying downside risk to the output gap. Monetary policy impacts the output gap directly through the investment-savings curve, and indirectly through its impact on the tightness of the value-at-risk constraint. The optimal monetary policy rule always depends on financial vulnerabilities in addition to output, inflation, and the real rate. We show that a classic Taylor rule exacerbates downside risk to GDP growth relative to an optimal Taylor rule, thus generating welfare losses associated with negative skewness of GDP growth.

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