Monetary policy rule under rare events: With implications by digital finance development

Abstract

This article studies the macroeconomic impacts of rare events and the choice of monetary policy rule in an estimated DSGE model using Chinese data. We quantify the characteristics of adverse macroeconomic effects on both the supply and demand side and explore the suitable monetary policy response in the context of digital finance development. The results show that the early stage of severe negative macroeconomic impacts amplified by financial frictions requires quantity-based tools to restore macroeconomic stability. After the impediment of financial frictions and the early impact of rare events are mitigated, price-based tools are more effective than quantity-based tools in achieving a rapid recovery. Therefore, a mixed monetary policy rule shows the advantage of flexibility and results in the highest welfare. In addition, digital finance development reduces financial frictions and stabilizes money demand, thus enhancing the relative importance of price-based tools.