Financial Stability, Deflation, and Monetary Policy
AbstractThe 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 InfoArticle 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)
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Other versions of this item:
- Marvin Goodfriend, 2001. "Financial stability, deflation, and monetary policy," Working Paper 01-01, Federal Reserve Bank of Richmond.
- E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
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