Monetary Policy under Financial Uncertainty ∗

This paper considers the role of monetary policy in mitigating the effects of financial crises. I suppose that the economy occasionally but infrequently experiences crises, where financial variables directly affect the broader real economy. I analyze the formulation of monetary policy under such financial uncertainty, where policymakers recognize the possibility of financial crises, which leads to uncertainty about the transmission of financial market conditions to the broader economy. I show how this uncertainty changes desirable monetary policies. In the model, monetary policy does not affect the likelihood or magnitude of crises, but may cushion their impact. In general, policy is affected both during the crisis itself and in normal times, as policymakers guard against the possibility of crises. In the estimated model we consider, this effect is quite small. Optimal policy does change substantially during a crisis, but uncertainty about crises has relatively little effect. JEL Classification: E42, E52, E58