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Financial Stability and Monetary Policy: How Closely Interlinked?

  • Frank Smets

    (European Central Bank)

The recent financial crisis has again raised the question to what extent price-stability-oriented monetary policy frameworks should take into account financial stability objectives. In this paper I argue that the answer will depend on three questions: (i) how effective is macroprudential policy in maintaining financial stability? (ii) what is the effect of monetary policy on risk taking and financial stability? and (iii) what is the risk of financial dominance, i.e., the risk that financial stability considerations undermine the credibility of the central bank’s price stability mandate? I review the theory and evidence and conclude that while the new macroprudential policy framework should be the main tool for maintaining financial stability, monetary policy authorities should also keep an eye on financial stability. This will allow the central bank to lean against the wind if necessary, while maintaining its primary focus on price stability over the medium term.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 10 (2014)
Issue (Month): 2 (June)
Pages: 263-300

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Handle: RePEc:ijc:ijcjou:y:2014:q:2:a:11
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  1. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  2. Angeloni, Ignazio & Faia, Ester, 2013. "Capital regulation and monetary policy with fragile banks," Journal of Monetary Economics, Elsevier, vol. 60(3), pages 311-324.
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  8. Crowe, Christopher & Dell’Ariccia, Giovanni & Igan, Deniz & Rabanal, Pau, 2013. "How to deal with real estate booms: Lessons from country experiences," Journal of Financial Stability, Elsevier, vol. 9(3), pages 300-319.
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  10. Stephen G Cecchetti & Marion Kohler, 2012. "When capital adequacy and interest rate policy are substitutes (and when they are not)," BIS Working Papers 379, Bank for International Settlements.
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  13. Itai Agur & Maria Demertzis, 2010. "Monetary Policy and Excessive Bank Risk Taking," DNB Working Papers 271, Netherlands Central Bank, Research Department.
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  15. Giovanni Dell'Ariccia & Luc Laeven & Gustavo Suarez, 2013. "Bank Leverage and Monetary Policy's Risk-Taking Channel; Evidence from the United States," IMF Working Papers 13/143, International Monetary Fund.
  16. Philip Lowe & Claudio Borio, 2002. "Asset prices, financial and monetary stability: exploring the nexus," BIS Working Papers 114, Bank for International Settlements.
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