Abstract
We consider whether or not a central bank should respond directly to financial market conditions when setting monetary policy. Specifically, should a central bank put weight on interbank lending spreads in its Taylor rule policy function? Using a model with risk and balance sheet effects in both the real and financial sectors (Davis, The Adverse Feedback Loop and the Effects of Risk in the both the Real and Financial Sectors Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute Working Paper No. 66, November 2010) we find that when the conventional parameters in the Taylor rule (the coefficients on the lagged interest rate, inflation, and the output gap) are optimally chosen, the central bank should not put any weight on endogenous fluctuations in the interbank lending spread. However, the central bank should adjust the risk free rate in response to fluctuations in the spread that occur because of exogenous financial shocks, but we find that the central bank should not be too aggressive in its easing policy. Optimal policy calls for a two-thirds of a percentage point cut in the risk free rate in response to a financial shock that causes a one percentage point increase in interbank lending spreads.
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