The recent financial crisis has again raised the question to what extent price-stability-oriented monetary policy frameworks should take into account financial stability objectives. In this paper I argue that the answer will depend on three questions: (i) how effective is macroprudential policy in maintaining financial stability? (ii) what is the effect of monetary policy on risk taking and financial stability? and (iii) what is the risk of financial dominance, i.e., the risk that financial stability considerations undermine the credibility of the central bank’s price stability mandate? I review the theory and evidence and conclude that while the new macroprudential policy framework should be the main tool for maintaining financial stability, monetary policy authorities should also keep an eye on financial stability. This will allow the central bank to lean against the wind if necessary, while maintaining its primary focus on price stability over the medium term.

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Financial Stability and Monetary Policy: How Closely Interlinked?

A number of commentators have argued that the desirability of inflation targeting as a framework for monetary policy analysis should be reconsidered in light of the global financial crisis, on the ground that it requires neglect of the implications of monetary policy for financial stability. This paper argues that monetary policy may indeed affect the severity of risks to financial stability, but that it is possible to generalize an inflation targeting framework to take account of financial stability concerns alongside traditional stabilization objectives. The resulting framework can still be viewed as a form of flexible inflation targeting; in particular, the paper proposes a target criterion that would still imply an invariant long-run price level, despite fluctuations over time in risks to financial stability or even the occurrence of occasional financial crises.

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Inflation Targeting and Financial Stability

This paper analyses the impact on the macroeconomy of the ECB’s non-standard monetary policy implemented in the aftermath of the collapse of Lehman Brothers in the Fall of 2008. We study in particular the effect of the expansion of the intermediation of transactions across central bank balance sheets as dysfunctional financial markets seize up, which we regard as a key channel of transmission for non-standard monetary policy measures. Our approach is similar to Lenza et al., 2009 but we introduce the important innovation of distinguishing between private intermediation of interbank transactions in the money market and central bank intermediation of bank-to-bank transactions across the Eurosystem balance sheet. We do this by exploiting data drawn from the aggregate Monetary and Financial Institutions (MFI) balance sheet which allows us to construct a new measure of the ‘policy shock’ represented by the ECB’s increasing role as a financial intermediary. We find that bank loans to households and, in particular, to non-financial corporations are higher than would have been the case without the ECB’s intervention. In turn, the ECB’s support has a significant impact on economic activity: two and a half years after the failure of Lehman Brothers, the level of industrial production is estimated to be 2% higher, and the unemployment rate 0.6 percentage points lower, than would have been the case in the absence of the ECB’s non-standard monetary policy measures.

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The ECB and the Interbank Market

We provide explicit solutions for government spending multipliers during a liquidity trap and within a fixed exchange regime using standard closed and open-economy models. We confirm the potential for large multipliers during liquidity traps. For a currency union, we show that self-financed multipliers are small, always below unity. However, outside transfers or windfalls can generate larger responses in output, whether or not they are spent by the government. Our solutions are relevant for local and national multipliers, providing insight into the economic mechanisms at work as well as the testable implications of these models.

Fiscal Mulipliers: Liquidity Traps and Currency Unions

The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability, raising questions about how to combine monetary and prudential policies. This paper characterizes the jointly optimal monetary and prudential policies, setting the interest rate and bank-capital requirements. The source of financial fragility is the socially excessive risk taking by banks due to limited liability and deposit insurance. We provide conditions under which locally (Ramsey) optimal policy dedicates the prudential instrument to preventing inefficient risk taking by banks, and the monetary instrument to dealing with the business cycle, with the two instruments covarying either negatively, or positively and countercyclically.

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Optimal Monetary and Prudential Policies

The article deals with the interaction between monetary policy
and financial stability. The discussion is focused on the
impact of the world financial crisis on monetary policy
orientation. The question is raised whether the established
consensus on the goals and instruments of monetary policy still
holds. In the pre-crisis period the mainstream approach
considered price stability and financial stability as two
separated goals to be achieved through different policies and
instruments. Monetary policy safeguards price stability whereas
regulatory and supervisory framework is responsible for
financial stability. The instruments of monetary policy were
expected to cope only with the consequences of financial
imbalances and asset price bubbles, ex post correcting their
negative impact on the economy. Lessons from the financial
crisis heed to a reassessment of that approach. In the article
the ways towards a more active engagement of monetary policy in
preserving financial stability are examined. The view is held
that financial imbalances should be reacted to already in the
process of their formation, once they create a systemic risk
and threaten to cause financial disarray. Though the views on
the possible options diverge as yet, the role of financial
stability concerns in monetary policy making is likely to keep
increasing in the foreseeable future.

Monetary Policy and Financial Stability

The article identifies causes of the world financial crisis and
its impact on monetary policy and central banking. Under the
pressure of crisis, the standard monetary policy of previous
periods shifted to unconventional instruments of “quantitative
easing”. This change represents move away from technical
monetary policy towards a more activist approach. Will this
shift be only temporary and monetary policy will return to
traditional standards as the crisis subsides? Or will its
impact be of a more permanent character? The article examines
the applied unconventional monetary policy measures, their
consequences and risk involved. For the past decades central
banking has been dominated by consensus which holds the view
that central bankers prime task is to keep inflation low and
stable. Learning the lesson from the current crisis the article
discusses the arguments whether monetary policy should be and
could be more oriented to the broader issues of financial
stability, not just price stability.

Miroslav Hrnčíř

Papers

Monetary Policy and Financial Stability

Monetary Policy and Central Banking in the Wake of the WorldFinancial Crisis