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The Nexus Between Monetary Policy and Financial Stability

Paper Session

Friday, Jan. 5, 2018 8:00 AM - 10:00 AM

Pennsylvania Convention Center, 201-B
Hosted By: American Economic Association
  • Chair: Mark Gertler, New York University

The Tradeoffs in Leaning Against the Wind

Anil Kashyap
,
University of Chicago and Bank of England
Francois Gourio
,
Federal Reserve Bank of Chicago
Jae Sim
,
Federal Reserve Board

Abstract

Credit booms sometimes lead to financial crises which are accompanied with severe and persistent economic slumps. Does this imply that monetary policy should "lean against the wind" and counteract excess credit growth, even at the cost of higher output and inflation volatility? We study this issue quantitatively in a standard small New Keynesian dynamic stochastic general equilibrium model which includes a risk of financial crisis that depends on "excess credit". We compare monetary policy rules that respond to the output gap to rules that respond to excess credit. We find that leaning against the wind may be attractive, depending on several factors, including (1) the severity of financial crises; (2) the sensitivity of crisis probability to excess credit; (3) the volatility of excess credit.

Financial Vulnerability and Monetary Policy

Tobias Adrian
,
International Monetary Fund
Fernando Duarte
,
Federal Reserve Bank of New York

Abstract

We present a microfounded New Keynesian model that features financial vulnerabilities. Financial intermediaries' occasionally binding value at risk constraints give rise to variation in the pricing of risk that generates time varying risk in the conditional mean and volatility of the output gap. The conditional mean and volatility are negatively related: during times of easy financial conditions, growth tends to be high, and risk tends to be low. Monetary policy affects output directly via the IS curve, and indirectly via the pricing of risk that relates to the tightness of the value at risk constraint. The optimal monetary policy rule always depends on financial vulnerabilities in addition to the output gap, inflation, and the natural rate. We show that a classic Taylor rule exacerbates deviations of the output gap from its target value of zero relative to an optimal interest rate rule that includes vulnerability. Simulations show that optimal policy significantly increases welfare relative to a classic Taylor rule. Alternative policy paths using historical examples illustrate the usefulness of the proposed policy rule.

A Quantitative Case for Leaning Against the Wind

Andrew Filardo
,
Bank for International Settlements
Phurichai Rungcharoenkitkul
,
Bank for International Settlements

Abstract

Should a monetary authority lean against the build-up of financial imbalances? We study this policy question in an environment in which there are recurring cycles of financial imbalances that develop over time and eventually collapse in a costly manner. The optimal policy reflects the trade-off between the short-run macroeconomic costs of leaning against the wind and the longer-run benefits of stabilizing the financial cycle. We model the financial cycle as a nonlinear Markov regime-switching process, calibrate the model to US data and characterize the optimal monetary policy. Leaning systematically over the whole financial cycle is found to outperform policies of "benign neglect" and "late-in-the-cycle" discretionary interventions. This conclusion is robust to a wide range of alternative assumptions and supports an orientation shift in monetary policy frameworks away from narrow price stability to a joint consideration of price and financial stability.

Coordinating Monetary and Financial Regulatory Policies

Alejandro Van der Ghote
,
European Central Bank

Abstract

How to conduct macro-prudential regulation? How to coordinate monetary policy and macro-prudential policy? To address these questions, I develop a continuous-time New Keynesian economy in which a financial intermediary sector is subject to a leverage constraint. Coordination between monetary and macro-prudential policies helps to reduce the risk of entering into a …financial crisis and speeds up exit from the crisis. The downside of coordination is variability in inflation and in the employment gap.
Discussant(s)
Stefan Laséen
,
Sveriges Riksbank
Andrew Levin
,
Dartmouth College
David López-Salido
,
Federal Reserve Board
Anton Korinek
,
Johns Hopkins University
JEL Classifications
  • E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit
  • G0 - General