How does monetary policy respond to the dynamics of the shadow banking sector?

Abstract

We investigate the response of the central bank to the change in size of non-bank financial intermediaries. Using quarterly data for the U.S. over the period 1946:Q1-2016Q4, we find that when faced with an increase in the asset growth of the securities' brokers and dealers and the shadow banking sector, the monetary authority reacts by raising the short-term nominal interest rate. This response is stronger in the case of sharp variation in the size of the balance sheet of non-bank financial intermediaries. From a policy perspective, our study suggests that an extended version of the original Taylor rule - embedding both price stability and financial stability concerns –provides a good characterisation of the monetary policy reaction function.