Posted by: mulrickillion | October 11, 2011

Incorporating Financial Sector Risk into Monetary Policy Models: Application to Chile

By Dale Gray, Carlos García, Leonardo Luna, and Jorge E. Restrepo

International Monetary Fund (IMF), Working Paper No. 11/288, September 2011 —

Summary: This paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. The main question to be answered with the integrated model is whether or not the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. It is found in general, that including distance-to-default (dtd) of the banking system in the central bank reaction function reduces both inflation and output volatility. Moreover, the results are robust to different model calibrations: whenever exchange-rate pass-through is higher; financial vulnerability has a larger impact on the exchange rate, as well as on GDP (or the reverse, there is more effect of GDP on bank’s equity – i.e., what we call endogeneity), it is more efficient to include dtd in the reaction function.

[An excerpt from the Working Paper reads]:

The integration of the analysis of financial sector vulnerability into macroeconomic models is an area of important and growing interest for policymakers, in both developed and emerging markets. Monetary policy models and financial stability models, by their nature, are very different frameworks. Monetary policy models are widely used by central banks to understand the transmission mechanisms of interest rates to the macroeconomy and inflation. On the other hand, estimating the effect of shocks to vulnerability on the risk of banks in a coherent manner requires both a model of banking sector risk and a tractable methodology for simulating shocks and estimating their effect on various risk measures.

This article analyzes whether monetary policy models should include market-based financial stability indicators (FSIs) or not, and, if so, how. Since the economy and interest rates affect financial sector credit risk, and the financial sector affects the economy, this paper builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. More specifically, we use the model to answer the question whether the central bank should include explicitly the financial stability indicator in its monetary policy (interest rate) reaction function. The alternative would be to react only indirectly to financial risk by reacting to inflation and GDP gaps, since they already include the effect financial factors have in the economy.

Market-based financial stability indicators (FSIs) summarize both the credit channel and credit risk transmission from distressed borrowers in the economy. Market-based FSIs provide information on the banking sector’s financial condition which is related to the quantity of credit extended and the possible or expected effects of this channel on the real economy and GDP (credit expansion and the “financial accelerator”). Market-based FSIs also capture the reduced financial soundness of banks when borrowers default in periods of economic distress which leads to lower value of risky debt and thus to lower banking sector assets, higher banking asset volatility. This is a reflection of the economic condition of borrowers and of the real economy. (Note that when the banking sector is in distress, bank assets and bank equity values are lower and volatility of bank assets and bank equity is much higher). . . .

>>Read the full Working Paper here (wp11288.pdf).

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