DP14435 Monetary and Macroprudential Policy with Endogenous Risk

Author(s):	Tobias Adrian, Fernando Duarte, Nellie Liang, Pawel Zabczyk
Publication Date:	February 2020
Keyword(s):	Macro-Finance, macroprudential policy, monetary policy
JEL(s):	E32, E44, E52, G28
Programme Areas:	Monetary Economics and Fluctuations
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=14435

We extend the New Keynesian (NK) model to include endogenous risk. Lower interest rates not only shift consumption intertemporally but also conditional output risk via the impact on risk-taking, giving rise to a vulnerability channel of monetary policy. The model fits the conditional output gap distribution and can account for medium-term increases in downside risks when financial conditions are loose. The policy prescriptions are very different from those in the standard NK model: monetary policy that focuses purely on inflation and output-gap stabilization can lead to instability. Macroprudential measures can mitigate the intertemporal risk-return tradeoff created by the vulnerability channel.