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Financial Stability, Deflation, and Monetary Policy

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  • Goodfriend, Marvin

    (Federal Reserve Bank of Richmond)

Abstract

The paper explores the relationship between financial stability, deflation, and monetary policy. A discussion of narrow liquidity, broad liquidity, market liquidity, and financial distress provides the foundation for the analysis. There are two preliminary conclusions. Equity prices are a misleading guide for interest rate policy. Monetary policy tactics protect market liquidity while maximizing the central bank's leverage over longer-term interest rates and aggregate demand. Monetary policy is a fundamental source of deflation and stagnation risk when price stability is fully credible. A central bank can be fooled by its own credibility for low inflation into being insufficiently preemptive in a business expansion. Then monetary policy can be constrained by the zero bound from reducing real interest rates enough in the subsequent contraction. The chain of events that leads to deflation and stagnation can be weakened or broken in a number of places. Monetary policy has the power to preempt deflation and the power to overcome the zero bound to restore prosperity after a deflationary shock. Fiscal policy is likely to be relatively ineffective at best and counterproductive at worst.

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Bibliographic Info

Article provided by Institute for Monetary and Economic Studies, Bank of Japan in its journal Monetary and Economic Studies.

Volume (Year): 19 (2001)
Issue (Month): S1 (February)
Pages: 143-167

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Handle: RePEc:ime:imemes:v:19:y:2001:i:s1:p:143-167

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Cited by:
  1. M. Zouaoui & G. Nouyrigat & F. Beer, 2010. "How does investor sentiment affect stock market crises? Evidence from panel data," Post-Print halshs-00534754, HAL.
  2. R. Kato & S. Nishiyama, 2002. "Optimal Monetary Policy When Interest Rates are Bounded at Zero," Computing in Economics and Finance 2002 8, Society for Computational Economics.
  3. Bergman, U. Michael & Hansen, Jan, 2002. "Financial Instability and Monetary Policy: The Swedish Evidence," Working Paper Series 137, Sveriges Riksbank (Central Bank of Sweden).
  4. repec:hal:cesptp:hal-00308557 is not listed on IDEAS
  5. Christian Bordes & Laurent Clerc, 2007. "Price Stability And The Ecb'S Monetary Policy Strategy," Journal of Economic Surveys, Wiley Blackwell, vol. 21(2), pages 268-326, 04.
  6. Thorsten V. Koeppl, 2009. "How Flexible Can Inflation Targeting Be? Suggestions for the Future of Canada's Targeting Regime," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 293, August.
  7. Takatoshi Ito & Frederic S. Mishkin, 2004. "Two Decades of Japanese Monetary Policy and the Deflation Problem," NBER Working Papers 10878, National Bureau of Economic Research, Inc.
  8. Jun Nagayasu, 2003. "The Term Structure of Interest Rates and Monetary Policy During a Zero-Interest-Rate Period," IMF Working Papers 03/208, International Monetary Fund.

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