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Should Monetary Policy Target Financial Stability?

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Abstract

Monetary policy can promote financial stability and improve household welfare. We consider a macro model with a financial sector in which banks do not actively issue equity, output and growth depend on the aggregate level of bank equity, and equilibrium is inefficient. Monetary policy rules responding to the financial sector are ex-ante stabilizing because their effects on risk premia decrease the likelihood of crises and boost leverage during downturns. Stability gains from monetary policy increase welfare whenever macroprudential policy is poorly targeted. If macroprudential policy is sufficiently well-targeted to promote financial stability, then monetary policy should not target financial stability.

Suggested Citation

  • William Chen & Gregory Phelan, 2021. "Should Monetary Policy Target Financial Stability?," Department of Economics Working Papers 2021-12, Department of Economics, Williams College.
    • Handle: RePEc:wil:wileco:2021-12
    DOI: 10.36934/wecon:2021-12
    Note: This is a revision of working paper 2020-01
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    Cited by:

    1. William Chen & Gregory Phelan, 2024. "Liquidity Provision and Financial Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 56(2-3), pages 455-487, March.
    2. Peterson K. Ozili, 2025. "Reflecting on the Recent Banking Crisis, What Are the New Financial Stability Determinants?," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 54(2), July.
    3. Caio Machado, 2024. "Coordinating in Financial Crises," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 54, October.
    4. Chen, William & Phelan, Gregory, 2025. "Digital currency and banking-sector stability," Journal of Financial Stability, Elsevier, vol. 78(C).

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    Keywords

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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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