Financial crisis, effective policy rules and bounded rationality in a New Keynesian framework

Abstract

This paper extends a standard open-economy New Keynesian model to include a third-generation ''balance sheet effect'' which is made operational through an endogenous risk premium impacting on investment. Using rational expectations and adaptive learning solutions, the efficiency of alternative monetary policy rules is examined during a period of financial crisis. We find that the Taylor rule is the welfare superior policy, questioning the idea of an ''information encompassing'' inflation-forecast based rule. Under adaptive learning we find additional policy traction and less instrument variability in rules augmented with the exchange rate. All rules, however, advocate a sharp initial interest rate response to the crisis.

Monetary Transmission of Persistent Shock to the Risk Premium: The Case of Indonesia

“…I follow Al-Eyd and Hall (2006), Murchison, et. al (2004), and Schmitt-Grohe and Uribe ( 2003) in defining the country-specific risk premium, κ t , which depends on net foreign debtto-GDP ratio.…”

Monetary Transmission of Persistent Shock to the Risk Premium: The Case of Indonesia

“…Penulis mengikuti Al-EYD dan Hall (2006), Murchison, et. al (2004), dan Schmitt-Grohe dan Uribe (2003) dalam menentukan premi resiko negara tertentu, κ t , yang bergantung pada rasio utang bersih asing terhadap PDB.…”