Financial Instability Prevention

The paper attempts to assess to what extent the central bank or the government should respond to developments that cause financial instability, such as housing or asset bubbles, overextended fiscal policies, or excessive public or household debt. To analyze this question we set up a simple reduced-form model in which monetary and fiscal policy interact, and consider several scenarios with both benevolent and idiosyncratic policymakers. The analysis shows that the answer depends on certain characteristics of the economy, as well as on the degree of ambition and conservatism of the two policymakers. Specifically, we identify circumstances under which financial instability prevention is best carried out by: (i) both monetary and fiscal policy ('sharing'), (ii) only one of the policies ('specialization'), and (iii) neither policy ('indifference'). In the former two cases there are circumstances under which either policy should be more pro-active than the other, and also circumstances under which fiscal policy should be ultra-active: ie care about nothing but the prevention of financial instability. These results are important in the context of the current crisis. We also show that neither the government nor the central bank should be allowed to freely select the degree of their activism in regard to financial instability threats. This is because of a moral hazard problem: both policymakers have an incentive to be insufficiently pro-active, and shift the responsibility to the other policy. Such behaviour has strong implications for the optimal design of the delegation process.