Working Paper: CEPR ID: DP14435
Authors: Tobias Adrian; Fernando Duarte; Nellie Liang; Pawel Zabczyk
Abstract: 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.
Keywords: monetary policy; macroprudential policy; macrofinance
JEL Codes: E52; E32; E44; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lower interest rates (E43) | Increased conditional output risk (G19) |
| Increased conditional output risk (G19) | Output volatility (C69) |
| Lower interest rates (E43) | Risk-taking behavior (D91) |
| Risk-taking behavior (D91) | Increased conditional output risk (G19) |
| Macroprudential measures (E44) | Mitigation of intertemporal risk-return tradeoff (D15) |
| Monetary policy (E52) | Stability of financial conditions (E44) |
| Macroprudential policy + Monetary policy (E63) | Economic stability (E60) |
| NK model's standard policy prescriptions (E69) | Financial instability (F65) |