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Trading off monetary and financial stability: a balance of risk framework

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  • Jan Willem van den End

Abstract

This paper presents a framework that quantifies the trade-offs for a central bank that includes financial stability in its strategy and uses macroprudential instruments next to the interest rate. It is an innovative application of the Kaminsky and Reinhart early warning method, by assuming that the central bank takes into account financial variables as signals of inflation risks. The empirical application shows that trading off monetary and macroprudential policy reduces the overall costs related to inflation and financial instability. This can be achieved by changing the preferences of the central bank, lengthening the monetary policy horizon and by a more flexible inflation target. Estimation results of a probit model indicate that the monetary stance in the US and the Euro area has not adequately traded off price stability against financial stability.

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File URL: http://www.dnb.nl/binaries/249%20Trading%20off%20monetary%20and%20financial%20stability_tcm46-233693.pdf
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Bibliographic Info

Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 249.

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Date of creation: May 2010
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Handle: RePEc:dnb:dnbwpp:249

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Keywords: financial stability; macroprudential policy; monetary policy; policy co-ordination; inflation;

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