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Since the financial crisis, there has been an active debate about whether and how monetary policy frameworks should incorporate risks to financial stability. The debate has moved beyond the pre-crisis focus on the ability of policymakers to identify asset bubbles and whether monetary policy can stop asset prices from continuing to rise. Research has advanced on adding financial intermediary frictions into monetary policy models. Woodford (2010, 2012) proposes incorporating a credit spread as a third variable in an optimal monetary policy rule with flexible inflation targeting. Christiano et al. (2010) show that stock market booms tend to be accompanied by low inflation, suggesting that policy rules that focus narrowly on inflation targets will destabilise asset markets and the broader economy. Interest rate rules should thus allow an independent role for credit growth to reduce the volatility of output and asset prices.
In a recent paper, we review the growing research on the transmission channels of monetary policy through both financial conditions and financial vulnerabilities (Adrian and Liang 2016). Financial conditions refer to borrowing costs determined by the policy rate, including risk premia for risky assets above the risk-free term structure.
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