Are critics’ concerns for bank profitability a justification for the European Central Bank (ECB) to raise interest rates from the (zero) lower bound (ZLB), in particular if the ECB ascribed a more proactive role to financial stability objectives in its monetary policy? Using a monetary general equilibrium model with a banking sector, collateral default, and an autonomous central bank, we simulate the paths of inflation, output, bank profits, and default losses under optimal monetary and regulatory policy when the economy departs from the ZLB. Our findings do not support the argument that bank profitability will be restored upon departure from the ZLB. Instead they highlight the dragging effect on the price level when higher debt servicing costs increase losses from default away from the ZLB. It is precisely these losses from loan default that offset any gains from banks’ net interest margin. Monetary policy in our model operates beyond traditional channels, stressing the need to take into account Fisherian debt-deflation forces. Hence, there are merits to incorporating financial stability objectives in central banks’ objective function.
Work in Progress
“The Role of Financial Stability Objectives for Monetary Policy in Emerging Market Economies”
The interaction of financial stability and monetary policy has come to the forefront of attention of monetary policy makers. Whereas central banks in advanced economies (AEs) are increasingly adopting a “leaning-against-the-wind” policy stance while targeting inflation and the output gap, several central banks in emerging market economies (EMEs) still follow a single mandate – guaranteeing price stability. The question about the “right” number of mandates is isomorphic to the question about the “appropriate” monetary policy rule. We develop a small open economy New-Keynesian model with banks, endogenous corporate default, and incomplete markets to investigate (1) how monetary policy and financial stability objectives in the decision rule of the central bank affect dynamics and welfare in EMEs, and (2) whether central banks should consider financial stability objectives in their decision rule. Calibrated to the Mexican economy, the responses to an adverse shock to banks’ foreign funding support an interest rate rule augmented by a measure of default. Including a financial stability objective reduces the volatility in responses to an external shock on both the real and financial side of the economy.