Abstract:
We evaluate monetary policy which is conducted in a way that addresses financial
stability as an explicit monetary policy objective using a simple game
theoretic model analysing the strategic interaction between a central bank and
a financial sector. The extant literature in favour of “lean-against-the-wind”
(LATW) monetary policy calls for more flexibility and the use of longer policy-horizons.
We, therefore, assess monetary policy under discretion and under
commitment to an instrument rule. Our analysis supports that rule-based
LATW monetary policy outperforms the discretionary equivalent, in terms of
controlling inflation, anchoring inflation expectations to the central bank’s inflation
target and enhancing financial sector profitability. Under substantial
risks to financial stability, we conclude that rule-based LATW monetary policy
induces the financial sector to impose more prudence on its operation.
