Financial imbalances and gradualism

In the last years, in the major OECD economies, while inflation has become lower and more stable, episodes of financial instability and large cycles in asset prices have shown up with (often) non-negligible effects on economic activity. These facts should call for a larger concern with financial imbalances by the central bank. Adapting the model by Caplin and Leahy (1996)—where a central bank, which is uncertain about the state of the economy and its reaction to policy, seeks an optimal search strategy to influence private agents' responses—by substituting the central bank's price stability objective with a financial stability one, we find that the monetary authority should follow a less aggressive policy than the one suggested by the original model. However, initial conditions play a crucial role in determining the degree of gradualism by the policy maker with the policy becoming more and more aggressive as the initial interest rate shrinks.