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

• Published in: Economic change and restructuring Vol. 45; no. 1-2; pp. 25 - 44
• Main Authors: Al-Eyd, Ali J., Hall, Stephen G.
• Format: Journal Article
• Language: English
• Published: Boston Springer US 01-02-2012; Springer; Springer Nature B.V
• Series: Economic Change and Restructuring
• Subjects: Balance sheets; Bounded rationality; Crises; Debates; Development Economics; E43; E52; E58; Economic crisis; Economic Growth; Economic Policy; Economics; Economics and Finance; Emerging markets; Exchange rates; F41; Financial crises; Financial crisis; Foreign exchange rates; Indexing in process; Inflation; Interest rates; International Economics; Keynesian theory; Liability; Liability dollarization; Macroeconomics; Macroeconomics/Monetary Economics//Financial Economics; Monetary policy; Monetary policy rules; Political Economy/Economic Systems; Rational expectations; Rationality; Risk premiums; Studies; Liability dollarization; F41; E52; E43; Emerging markets; E58; Financial crises; Monetary policy rules; Bounded rationality
• ISSN: 1573-9414; 1574-0277
• DOI: 10.1007/s10644-011-9108-x

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.