Monetary Policy and Financial strongStabilitystrong What Role for the.pdf

Monetary Policy and Financial Stability: What Role for the Futures Market? # * ^ + John Driffill Zeno Rotondi Paolo Savona Cristiano Zazzara This Draft: 29th March 2005 (#) Birkbeck College, University of London. E-mail: j.driffill@bbk.ac.uk . (*) Capitalia Banking Group and University of Ferrara. E-mail: zeno.rotondi@capitalia.it and z.rotondi@economia.unife.it. (^) University “Luiss-Guido Carli” of Rome and Scuola Superiore della Pubblica Amministrazione. (+) Capitalia Banking Group (cristiano.zazzara@capitalia.it), University Luiss-Guido Carli of Rome (czazzara@luiss.it), and École Polytechnique Fédérale de Lausanne (cristiano.zazzara@epfl.ch). Abstract This paper examines interactions between monetary policy and financial stability. There is a general view that Central Banks smooth interest rate changes to enhance the stability of financial markets. But might this induce a moral hazard problem, and induce financial institutions to maintain riskier portfolios, the presence of which would further inhibit active monetary policy? Hedging activities of financial institutions, such as the use of interest rate futures and swap markets to reduce risk, should further protect markets against consequences of unforeseen interest rate changes. Thus smoothing may be both unnecessary and undesirable. The paper shows by a theoretical argument that smoothing interest rates may lead to indeterminacy of the economy’s rational expectations equilibrium. Nevertheless our empirical analysis supports the vie