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Bringing Financial Stability into Monetary Policy

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  • Eric M. Leeper
  • James M. Nason

Abstract

This paper arms central bank policy makers with ways to think about interactions between financial stability and monetary policy. We frame the issue of whether to integrate financial stability into monetary policy operating rules by appealing to the observation that in actual economies financial markets are incomplete. Incomplete markets create financial market frictions that prevent economic agents from perfectly sharing risk; in the absence of frictions, financial (in)stability would be of no concern. Overcoming these frictions to improve risk sharing across economic agents is, in our view, the intent of policies geared toward ensuring financial stability. There are many definitions of financial stability. Although the definitions share the notion that financial stability becomes an issue for policy makers when a breakdown in risk-sharing arrangements in financial markets has a negative effect on real economic activity, we give several examples that show this notion is too general for thinking about the role that monetary policy might have in smoothing shocks to financial stability. Examples include statistical models that seek to separate “good” from “bad” changes in private-sector debt aggregates, new Keynesian policy prescriptions grounded in neo-Wicksellian natural rate rules, and a historical episode involving the 1920s Federal Reserve. These examples raise a cautionary flag for policy attempts to control both the growth and the composition of debt that financial markets produce. We conclude with some advice for revising central banks’ Monetary Policy Reports.

Suggested Citation

  • Eric M. Leeper & James M. Nason, 2014. "Bringing Financial Stability into Monetary Policy," CAMA Working Papers 2014-72, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  • Handle: RePEc:een:camaaa:2014-72
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    Cited by:

    1. Mester, Loretta J., 2017. "The nexus of macroprudential supervision, monetary policy, and financial stability," Journal of Financial Stability, Elsevier, vol. 30(C), pages 177-180.
    2. Lewis, Vivien & Roth, Markus, 2018. "Interest rate rules under financial dominance," Journal of Economic Dynamics and Control, Elsevier, vol. 95(C), pages 70-88.
    3. Vivien Lewis & Stefania Villa, 2016. "The Interdependence of Monetary and Macroprudential Policy under the Zero Lower Bound," Working Paper Research 310, National Bank of Belgium.
    4. Leeper, E.M. & Leith, C., 2016. "Understanding Inflation as a Joint Monetary–Fiscal Phenomenon," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.), Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 2305-2415, Elsevier.
    5. Saroj Dhital & Pedro Gomis-Porqueras & Joseph H. Haslag, 2020. "Monetary and Fiscal Policy Interactions in a Frictional Model of Money, Nominal Public Debt and Banking," Working Papers 2002, Department of Economics, University of Missouri.
    6. Richard T. Froyen & Alfred V. Guender, 2017. "What to Aim for? The Choice of an Inflation Objective when Openness Matters," Open Economies Review, Springer, vol. 28(1), pages 167-190, February.
    7. Froyen, Richard T. & Guender, Alfred V., 2018. "The real exchange rate in Taylor rules: A Re-Assessment," Economic Modelling, Elsevier, vol. 73(C), pages 140-151.

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    More about this item

    Keywords

    Financial frictions; incomplete markets; crises; new Keynesian; natural rate; monetary transmission mechanism.;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • G2 - Financial Economics - - Financial Institutions and Services
    • N12 - Economic History - - Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations - - - U.S.; Canada: 1913-

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