Monetary policy and financial stability in the long run: a simple game-theoretic approach

Jin Cao, Lorán Chollete

    Research output: Contribution to journalArticlepeer-review

    8 Citations (Scopus)

    Abstract

    Many theoretical central bank models use short horizons and focus on a single tradeoff. However, in reality, central banks play complex, long-horizon games and face more than one tradeoff. We account for these strategic interactions in a simple infinite-horizon game with a novel tradeoff: tighter monetary policy deters financial imbalances, but looser monetary policy reduces the likelihood of insolvency. We term these factors discipline and stability effects, respectively. The central bank’s welfare decreases with dependence between real and financial shocks, so it may reduce costs with correlation-indexed securities. An independent central bank cannot in general attain both low inflation and financial stability.
    Original languageEnglish
    Pages (from-to)125-142
    Number of pages18
    JournalJournal of Financial Stability
    Volume28
    Early online date15 Dec 2016
    DOIs
    Publication statusPublished - Feb 2017

    Keywords

    • Central banking
    • Correlation-indexed security
    • Discipline effect
    • Stability effect
    • Strategic interaction

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