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Of course, most central banks have room for discretion and do not adhere mechanically to the rule implied by the prevailing framework. This was evident in the crisis response of most central banks, but largely only once the economic impact of the financial crisis started becoming evident, rather than in the run-up.
The limitation of this indicator is that spreads can also be affected by factors such as the availability of liquidity or a general decline in risk aversion.
One could argue that introducing financial stability into a conventional monetary policy framework would create tradeoffs between the objectives of a central bank In some circumstances, such tradeoffs may exist; however, such conflicts between the objectives of a central bank do not differ from those of a central bank that targets only price and output stability: for instance, as experienced in some circumstances, by showing more tolerance to the deviations of inflation than otherwise in order to stabilize output. However, we are not proposing an expansion of the mandate of the central bank; instead, we propose incorporating financial stability considerations in the conduct of an inflation targeting framework where price stability remains the mandate.
We should note that in practice, it may be difficult for a central bank to detect the sources of a shock. Nevertheless, the finding that an ITFS performs either better than or similar to (and no worse) the benchmark inflation targeting (ITB) rule would be of comfort for central bankers implementing this new IT framework.
This finding is also striking given that there is no consensus in the literature whether a central bank should limit financial risk-taking or encourage credit growth. For instance, Curdia and Woodford (2010) argue that a monetary policy response to credit would not help to stabilize the economy, since it is not clear whether encouraging or discouraging credit to the private sector helps to smooth the nature and persistence of disturbances in the economy.
Also, households’ balance sheet worsened less, since housing, which constitutes the majority of the household wealth, is highly regulated in Korea.
Trade is a very strong channel for Korea, and its importance during the 2000s was on an increasing trend. The share of imports and exports rose from around 55 percent of its GDP in 2001 to almost 90 percent in 2007.
This section provides the basic set up of the benchmark model. For details of the model, see Aydin and Volkan (forthcoming) IMF Working Paper.
This setup is the key aspect of the financial accelerator mechanism which was developed in Bernanke, Gertler, Gilchrist (1998). The setup links the balance sheets of the nonfinancial sector to that of the financial sector, and is key in capturing the amplifying effect of economic fluctuations.
The shock follows an autoregressive process with a persistence parameter of 0.95.
In all ITFS rules, except the one under scenario two, output volatility is smaller than how it would be under the benchmark case. Scenario two produces similar results as that of ITB.