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Macro prudential Policies and Financial Stability

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Author Info

  • Andrew Hughes Hallett

    (George Mason University, School of Public Policy, and CEPR)

  • Jan Libich

    ()
    (School of Economics, La Trobe University and CAMA)

  • Petr Stehlík

    ()
    (University of West Bohemia)

Abstract

The paper attempts to assess to what extent the central bank or the government should respond to developments that can cause financial instability, such as housing or asset bubbles, overextended budgetary policies, or excessive public and household debt. To analyse this question we set up a simple reduced-form model in which monetary and fiscal policy interact, and imbalances (bubbles) can occur in the medium-run. Considering several scenarios with both benevolent and idiosyncratic policy-makers, the analysis shows that the answer depends on a number of characteristics of the economy, as well as on the monetary and fiscal policy preferences with respect to inflation and output stabilization. We show that socially optimal financial instability prevention should be carried out by: (i) both monetary and fiscal policy (sharing region) under some circumstances, and (ii) fiscal policy only (specialization region) under others. There is however a moral hazard problem: both policy-makers have an incentive to be insufficiently pro-active in safeguarding financial stability, and shift the responsibility to the other policy. Specifically, under a range of circumstances we obtain a situation in which neither policy mitigates instability threats (indifference region). These results can be related to the build-up of the current global financial crisis, and have strong implications for the optimal design of the delegation process.

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File URL: http://www.latrobe.edu.au/__data/assets/pdf_file/0019/130915/2009.02.pdf
File Function: First version, 2009.02.pdf
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Bibliographic Info

Paper provided by School of Economics, La Trobe University in its series Working Papers with number 2009.02.

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Length: 25 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:trb:wpaper:2009.02

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Web page: http://www.latrobe.edu.au/economics
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Related research

Keywords: financial instability; bubbles; fiscal-monetary policy interaction; asset prices; public debt; deficit;

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References

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  1. Pierre L. Siklos & Martin T. Bohl, 2007. "Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule," Working Paper Series 32-07, The Rimini Centre for Economic Analysis, revised Jul 2007.
  2. Faia, Ester & Monacelli, Tommaso, 2007. "Optimal interest rate rules, asset prices, and credit frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3228-3254, October.
  3. Bordo, Michael D & Jeanne, Olivier, 2002. "Monetary Policy and Asset Prices: Does 'Benign Neglect' Make Sense?," International Finance, Wiley Blackwell, vol. 5(2), pages 139-64, Summer.
  4. Andrew Hughes Hallett & Jan Libich & Petr Stehlik, 2007. "Rogoff Revisited: The Conservative Central Banker Proposition Under Active Fiscal Policies," CAMA Working Papers 2007-20, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  5. Svensson, Lars & Faust, Jon, 1999. "The Equilibrium Degree of Transparency and Control in Monetary Policy," Seminar Papers 669, Stockholm University, Institute for International Economic Studies.
  6. Andrew Hughes Hallett & Jan Libich & Petr Stehlik, 2007. "Rogoff Revisited: The Conservative Central Banker Proposition Under Active Fiscal Policies," CAMA Working Papers 2007-20, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  7. Olivier Blanchard, 2009. "The State of Macro," Annual Review of Economics, Annual Reviews, vol. 1(1), pages 209-228, 05.
  8. Andrew Hughes Hallet & Jan Libich & Petr Stehlik, 2008. "Welfare Improving Coordination Of Fiscal And Monetary Policy," CAMA Working Papers 2008-04, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  9. Charles Bean, 2003. "Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough?," RBA Annual Conference Volume, in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  10. Andrew Hughes Hallet & Jan Libich & Petr Stehlik, 2008. "Welfare Improving Coordination Of Fiscal And Monetary Policy," CAMA Working Papers 2008-04, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  11. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  12. Frederic S. Mishkin, 2001. "The Transmission Mechanism and the Role of Asset Prices in Monetary Policy," NBER Working Papers 8617, National Bureau of Economic Research, Inc.
  13. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  14. Vickers, John, 2000. "Monetary Policy and Asset Prices," Manchester School, University of Manchester, vol. 68(0), pages 1-22, Supplemen.
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