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The central bank follows a Taylor-type rule in that it reacts to both inflation and the output gap. In addition, out of concern for financial

The central bank follows a Taylor-type rule in that it reacts to both inflation and the output gap. In addition, out of concern for financial market stability, it also reacts to movements in the risk premium from its equilibrium level ( ) . More precisely, if > , then the central bank lowers the policy interest rate ( i p ) in an effort to offset the negative effects on demand and vice versa. Thus

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