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Optimal Monetary Policy Under Financial Sector Risk

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Executive Summary

The authors consider whether or not a central bank should respond directly to financial market conditions when setting monetary policy. Specifically, should a central bank put weight on interbank lending spreads in its Taylor rule policy function? Using a model with risk and balance sheet effects in both the real and financial sectors they find that when the conventional parameters in the Taylor rule (the coefficients on the lagged interest rate, inflation, and the output gap) are optimally chosen, the central bank should not put any weight on endogenous fluctuations in the interbank lending spread.

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