The Trade-off between Monetary and Financial Stability: Some Lessons from the 2007–2008 Crisis for Emerging Economies

Until the recent financial crisis of 2007–2008, the conventional view was that the goals of price stability and financial stability are complementary ('one tool, one target'). The recent crisis, however, vividly demonstrated that monetary and financial stability, and the instruments that are used to achieve them, are much more interrelated than previously thought. The recent crisis and the reactions to it have raised three questions in this regard: (a) What are the possible trade-offs between monetary and financial stability, (b) how are these interactions exacerbated in emerging economies, and (c) what can be done to improve the terms of the trade-off? The purpose of this paper is to explore the trade-offs and to suggest measures and policies aimed to improve them, with particular focus on emerging economies. One clear policy lesson from our analysis is that monetary policy instruments, such as the monetary interest rate, aimed at achieving price stability, may simultaneously affect financial stability and thus necessitate adjusting other sets of policy instruments (e.g., the capital ratio and reserves requirements), which are aimed at maintaining financial stability.