Optimal Policy Implications of Financial Uncertainty

Kantur, Zeynep and Özcan, Gülserim (2019): Optimal Policy Implications of Financial Uncertainty.

Abstract

In addition to the stabilization of inflation and output gap, the responsibility of preventing financial crises and providing stable financial system is assumed by the central banks. In the aftermath of the Great Recession, the policymakers gave financial stability mandate more prominence to preemptively obliterate the fluctuations in the financial market. New models with alternative policy tools have emerged during this period to analyze the impact of financial shocks, and their linkages with the real economy. However, for the policymaker, it might not be possible to verify these models with existing information, which leads to uncertainty. This paper proposes robust optimal policy under uncertainty in response to financial and inflation shocks by acknowledging financial stability as an explicit objective of monetary policy. To do so, we extend the framework of De Paoli and Paustian (2017) by introducing model misspecification. We show that model ambiguity in the financial side requires a passive monetary policy stance. However, if the uncertainty originates from the supply side of the economy, an aggressive response of interest rate is required. We also show the contribution of an additional tool to the dynamics of the economy.

• Item Type: MPRA Paper
• Language: English
• Keywords: Financial Uncertainty, Financial Stability, Optimal Monetary Policy, Robust Control
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies

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