The role of financial imbalances in monetary policy
AbstractOne fundamental lesson of the financial crisis is that the evolution of financial imbalances may suggest overheating in the economy, which does not necessarily entail a rise in inflation. The bursting of these bubbles may result in an abrupt overshooting of the positive output gap in the opposite direction, in other words, it can lead to a severe recession. Thus, in addition to inflation and growth forecasts, central banks endeavouring to stabilise income fluctuations need to develop new indicators which are suitable for grasping the output gaps which evolve during the development of financial imbalances. This would require models that capture shocks in the banking systems and financial frictions in an endogenous way, but such models are still in their infancy. Over the short run, the only feasible opportunity is to derive indicators with good forecasting qualities directly from the indicators that characterise the imbalance, which are then considered by the Monetary Council in the form of expert information during the decision-making process. There is no need to change the framework of inflation targeting. However, in the future greater emphasis should be laid on the fact that anchoring inflationary expectations is a necessary, but not sufficient prerequisite to creating macro-economic stability, and that measures taken to avoid financial imbalances help to dampen income fluctuations. As the usual instruments are highly inefficient for stabilising the output gap caused by financial imbalances, the occasional application of macro-prudential instruments needs to be considered.
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Bibliographic InfoArticle provided by Magyar Nemzeti Bank (the central bank of Hungary) in its journal MNB Bulletin.
Volume (Year): 5 (2010)
Issue (Month): 2 (June)
monetary strategy; boom bust; asset prices; regulation; central banking.;
Find related papers by JEL classification:
- E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G20 - Financial Economics - - Financial Institutions and Services - - - General
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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