Financial Instability and Optimal Monetary Policy Rule

This paper investigates the effect of financial instability on the design of monetary policy rule for a small open economy. We find evidence that optimal monetary policy rule reacts directly to financial imbalances and, as a result, to the real exchange rate movements. However, optimal rule would not react to the real exchange rate changes directly if central bank does not care about the financial instability. For a quantitative analysis, impulse responses of some macroeconomic variables and financial instability to the domestic productivity and foreign country output shocks, resulting from simulation, are also analysed in this paper.