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 ?scal 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.
|Date of creation:||Jun 2009|
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References listed on IDEAS
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- Pierre Siklos & Martin Bohl, 2009.
"Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule,"
Open Economies Review,
Springer, vol. 20(1), pages 39-59, February.
- P. Siklos & M. Bohl, 2006. "Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule," Working Papers eg0053, Wilfrid Laurier University, Department of Economics, revised 2006.
- 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.
- 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.
- Bordo, Michael D & Jeanne, Olivier, 2002. "Monetary Policy and Asset Prices: Does 'Benign Neglect' Make Sense?," International Finance, Wiley Blackwell, vol. 5(2), pages 139-164, Summer.
- Olivier D Jeanne & Michael D. Bordo, 2002. "Monetary Policy and Asset Prices; Does "Benign Neglect" Make Sense?," IMF Working Papers 02/225, International Monetary Fund.
- Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
- Hughes Hallett, Andrew & Libich, Jan & Stehlík, Petr, 2007. "Monetary and Fiscal Policy Interaction with Various Degrees and Types of Commitment," CEPR Discussion Papers 6586, C.E.P.R. Discussion Papers.
- Jan Libich & Andrew Hughes Hallett & Petr Stehlik, 2007. "Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment," CAMA Working Papers 2007-21, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
- Vickers, John, 2000. "Monetary Policy and Asset Prices," Manchester School, University of Manchester, vol. 68(0), pages 1-22, Supplemen.
- 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.
- Tommaso Monacelli & Ester Faia, 2005. "Optimal Interest Rate Rules, Asset Prices and Credit Frictions," Computing in Economics and Finance 2005 452, Society for Computational Economics.
- 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. Full references (including those not matched with items on IDEAS)
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