Monetary Policy, Financial Stability and Interest Rate Rules

Abstract

This paper investigates the empirical properties of simple interest rate rules that embed either “backward” or “forward” interest rate smoothing. Such interest rate rules can be rationalized as the operative reaction functions used by central banks pursuing monetary policy and financial stability targets. We explicitly consider the implications of banks’ risk management practices for monetary policy and we derive interest rate rules by modeling the desire of the central bank to stabilize different definitions of the “basis” risk as a contribution to financial stability.This paper investigates the empirical properties of simple interest rate rules that embed either “backward” or “forward” interest rate smoothing. Such interest rate rules can be rationalized as the operative reaction functions used by central banks pursuing monetary policy and financial stability targets. We explicitly consider the implications of banks’ risk management practices for monetary policy and we derive interest rate rules by modeling the desire of the central bank to stabilize different definitions of the “basis” risk as a contribution to financial stability.Invited Submission