Introducing financial stability considerations into Taylor rules in emerging market economies

Abstract

We study optimized Taylor rules that incorporate financial stability considerations, which have been little analysed for emerging market economies. Setting the policy interest rate with a greater financial stability consideration reduces monetary policy effectiveness: a greater effort to reduce output volatility in the nontradables sector, where asset bubbles are prone to build, leads to greater inflation volatility.

Keywords:

• emerging market economies
• financial stability
• monetary policy
• Taylor rules

JEL Classification:

• E43
• E52
• E58
• F36

Notes

¹ , the target inflation rate, is set to zero without loss of generality.

² Brazil, Chile, Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Philippines, Poland, South Africa, Thailand and Turkey. Parameters estimated for three regions (Asia; Latin America; Eastern Europe; Middle East and Africa) separately are broadly similar. We set α₁₁ = 0.60, α₁₃ = 0.05, α₁₄ = –0.10, α₁₅ = –0.20, α₂₁ = 0.15, α₂₂ = 0.75, α₂₃ = 0.10, α₃₃ = 0.85, α₃₅ = –0.50, α₄₁ = 0.10, α₄₃ = 0.10, α₄₄ = 0.70, α₄₅ = 0.20. The size and signs of the coefficients are mostly economically plausible; see Gadanecz et al. (2014) for further details. In our estimations and subsequent simulations, all variables correspond to deviations from the equilibrium (or trend).

³ These increases are statistically insignificant, as the corresponding confidence intervals overlap.