Date Added: Feb 2010
This paper presents a model for the financial sector's vulnerability and integrates it into a macroeconomic framework commonly used in monetary policymaking. The main question to answer with the integrated model is whether central banks should explicitly include the financial stability indicator in the reaction function of the monetary policy interest rate. The results show that, in general, including the banking industry's Distance To Default (DTD) in the central bank's reaction function reduces both inflation and output volatility. In addition, the results are robust to different calibrations of the model.