Monetary Policy and Macro-Prudential Regulation: The Risk-Sharing Paradigm
How should monetary policy and macro-prudential regulation respond to the dangers of financial bubbles? I argue that bubbles - and their collapse - become a serious problem when there is inadequate risk-sharing. Neither monetary policy nor traditional macro-prudential regulation is designed to deal with this risk-sharing problem. Monetary policy has little hope of either accurately anticipating bubbles or dealing effectively with their consequences. Traditional approaches to macroprudential regulation are unlikely to succeed as they are based on the false premise that risk can always be quantified up front. I propose considering "ex-ante flexible contracting" as a longer-term response to the financial stability question.
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