Financial Stability and Monetary Policy: A Reduced-Form Model for the EURO Area

This paper is related to the growing academic literature on monetary policy and financial stability. In the first part, we propose a review of the literature on the subject, describing both theoretical and empirical models. In the second part, based on Filardo’s approach, we construct a reduced-form model for the Euro Area, addressing the need to include the financial stability objective into the ECB monetary policy decisions. The purpose of the paper is to see whether the ECB decisions can be improved if policymakers systematically react to financial instability signals. The novelty of the paper is the introduction of an aggregate financial instability index in the augmented Taylor’s rule that is a part of the proposed model. Our results show that, since the ECB setup until nowadays, the monetary policy decisions were influenced by the financial instability level, as indicated by the optimal policy rate. However, at the beginning and at the end of the analysed interval, we observe a discrepancy between the real key rate and the proposed optimal policy rule. More precisely, for the period 1999-2001, the model shows that the optimal rate ranged bellow the key rate, fact which shows that the ECB has intentionally fixed its initial interest rate to a much higher level in order to strengthen its credibility. In the same line, in 2009 the ECB should have decreased the key rate below the level of 1% to better overcome the lack of liquidity on the market. Our results also show that, towards the end of the analysed period (2010-2011), the ECB should have considerably increased the key rate to respond to inflation threats.