The optimal monetary policy response to adverse financial conditions is to slash the interest rate, argues a working paper published last week by the European Central Bank (ECB).

The paper, entitled ‘Monetary policy and the financing of firms', also posits that allowing short-term volatility in inflation against exogenous shocks can be useful, and that a straightforward application of the Taylor rule may yield undesirable outcomes.

It describes a model to clarify policy incentives created by the