Monetary Policy and Financial Stability Risks

The Evolution of Monetary Rules with Financial Stability Considerations

<ns3:p>This paper reviews literature on the empirical relationship between vulnerabilities in the financial system and the macroeconomy, and how monetary policy affects that connection. Financial vulnerabilities build up over time, with both risk appetite and risk taking rising during economic expansions. To some extent, financial crises are predictable and have severe real economic consequences when they occur. Empirically it is difficult to link monetary policy to financial vulnerabilities, in part because financial cycles have long durations, making it difficult to separate effects of changes in monetary policy from other business cycle effects.</ns3:p>

Monetary and macroprudential policy with foreign currency loans

Incorporating Financial Stability in Inflation Targeting Frameworks

Financial Stability Considerations in the Conduct of Monetary Policy

Money too tight to mention: The Reserve Bank of Australia’s financial stability mandate and low inflation

We develop a core–periphery model with financial frictions and cross-border banking to assess the magnitude of regulatory spillovers and the gains from macroprudential policy coordination. A core global bank lends to its affiliates in the periphery and banks in both regions are subject to risk-sensitive capital regulation. Following an expansionary monetary policy in the core, a countercyclical response in capital requirements in that region induces the global bank to increase cross-border lending. We calculate welfare gains associated with countercyclical capital buffers under a range of policy regimes, including independent policymaking, full coordination, and reciprocity—a regime in which capital ratios set in the core are imposed on the global bank’s affiliates abroad. One of our key results is that, even when regulatory spillovers are strong, reciprocity can make all parties better off if regulators attach a sufficient weight to financial stability considerations. With a standard, utility-based welfare criterion, reciprocity may also perform better than independent policymaking when regulatory spillovers are weak.

This paper explores how monetary policy affects the real economy and its efficacy in promoting financial stability in a large low income country. This paper shows that monetary policy modestly impacts real economic activity and inflation via the bank lending and financial accelerator channels. Second, money market and treasury rates signal changes in the policy stance, while altering banks’ intermediation cost curves due to shifting risk premia. At the same time, evidence points to monetary policy inducing an overshooting in asset prices. These findings suggest that financial stability could be undermined if the calibration of monetary policy is based solely on output and inflation without accounting for the stage of the financial cycle. Finally, the paper discusses policy measures that would enhance the transmission of monetary policy and promote financial stability in Bangladesh.

Strengthening the Monetary Policy Framework in Korea

Monetary Policy and Financial (In)Stability: An Integrated Micro-Macro Approach

The Politics of Central Bank Independence

The thesis is composed of three chapters which analyze the monetary and macro-prudential policy using a New Keynesian DSGE model with the banking sector. The first chapter evaluates the effectiveness of time-varying macro-prudential tools and their interaction with monetary policy using the model framework of Gertler and Karadi (2011) which emphasizes the role of bank capital and endogenous leverage constraint due to the moral hazard problem. We consider the following three types of countercyclical macro-prudential tools: (i) capital requirements (CAR), (ii) deposit-based reserve requirements (DBRR), and (iii) asset-based reserve requirements (ABRR). The main findings are as follows. First, all three types of macro-prudential policy tools reacting to the financial condition (credit to output gap) are effective to mitigate the fluctuation of credit and business cycle by weakening the pro-cyclicality of banks' net worth and the counter-cyclicality of the endogenous leverage and external finance premium. Second, the effectiveness of each instrument differs by the source of shocks to the economy. In response to a TFP shock, the counter-cyclical CAR is the most effective to mitigate the fluctuation of credit and output and the ABRR is relatively more effective in response to capital quality shocks (credit supply shock). Third, all types of macro-prudential tools are welfare improving in combination with monetary policy, but the use of macro-prudential policy is relevant in response to the credit supply shock (financial shock). Finally, when the economy is hit by a financial shock, a relatively direct tool like asset-based reserve requirement (ABRR) can be the most welfare-improving and the relationship between monetary and macro-prudential policy can be complementary each other. The second chapter examines the role of banks' endogenous reserves and capital and the usefulness of financial condition (credit aggregates and external finance premium) as an indicator for setting up a relevant monetary policy rule. For the task, I construct an extended version of Goodfriend and McCallum (2007) model which is characterized by banks' loan production function with inputs (collaterals, monitoring works and bank capital buffer) under the households' deposit in advance (DIA) constraint. Main findings are as follows. First, banks' endogenous reserves can mitigate the variation of external finance premium by substituting costly monitoring works for lending. However, the effect of endogenous reserves on output and credits depends on types of shocks (credit-demand vs credit-supply shock), which reflects the role of external finance premium (EFP) as a banking attenuator (pro-cyclical EFP) or financial accelerator (counter-cyclical EFP) respectively. Second, the effect of banks' endogenous reserves can be limited when banks can adjust their capital flexibly compared to when banks' keep their capital to asset ratio (leverage) stable. Third, considering the role of money and the frictions on the credit-supply side, monetary policy reacting actively to the financial condition is welfare improving. These results imply that quantitative easing (QE) policy during the crisis was effective but the effectiveness of QE can be limited when banks can lower their leverage in a pro-cyclical manner. And monetary policy should pay more attention to the financial condition and prevailing interest rates as well as inflation and output gap in the presence of substantive financial frictions on the credit supply side in particular when the banking shocks dominate the economy. In the last chapter (co-authored with Professor Jagjit S. Chadha), we investigate the question facing many emerging economies: the extent to which a workhorse advanced economy model can yield important insights for monetary policy-making. We note that the standard sticky-price, monopolistically competitive model does not allow analysis of money and credit dynamics and led to a concentration of research on simple interest rate reaction functions. However, time-varying financial frictions tend to act as a tax on intermediation activities and so can vary output in a significant manner. In this chapter, we consider the implications of financial frictions for baseline monetary policy using a model calibrated on Indian data and find that a simple interest rate reaction function may not be welfare maximizing when banking shocks are dominant in the economy.

The pre‐crisis low‐interest‐rate environment is raising concerns among researchers and policymakers about its impact on the triangle prudential policy‐monetary policy‐bank's risk‐taking. While interest rates are set at low level for inflationary and economic growth reasons, they may lead banks to take more risk, jeopardizing the financial system and impeding the recovery. This paper provides a literature review, on the one hand, on the interaction of monetary and prudential policies through their impacts on bank's risk‐taking, and on the other hand, on the issues of their coordination. Monetary policy appears to have ambiguous effects on banks’ profitability, and then, on banks’ risk‐taking behavior. Despite monetary and prudential policies pursue different objectives, they inevitably interact, raising challenges that face policymakers. Albeit it is argued that monetary policy alone is not sufficient to maintain macroeconomic and financial stability, and that it should be coordinated with prudential policy, the form of this coordination is not clear‐cut.

Financial stability is a crucial indicator of the financial sector's health, reflecting the system's resilience or vulnerability to crises. This study investigates the impact of macroeconomic variables and financial inclusion on financial stability in Indonesia, utilizing quarterly data from the first quarter of 2012 to the fourth quarter of 2021. Employing the Vector Error Correction Model (VECM), the research examines the influences of these factors in both the short and long term. The findings reveal that macroeconomic variables and financial inclusion significantly affect financial stability in Indonesia across both time frames. Specifically, inflation emerges as a critical factor influencing financial stability in the long term, while interest rates play a pivotal role in the short term. Moreover, financial inclusion, represented by the public's use of banking products and third-party funds relative to Gross Domestic Product (GDP), impacts financial stability both in the long and short term. Conversely, financial inclusion, measured by credit to GDP, exhibits only short-term effects on financial stability. The results underscore the importance of careful consideration by the central bank when formulating monetary policy, particularly regarding interest rate adjustments, due to their immediate impact on financial system stability. Over the long term, maintaining control over inflation rates is imperative to safeguard financial stability. Furthermore, financial institutions, in their role of fostering financial inclusion by distributing credit, must balance the quality of credit with its quantity to avoid negative impacts on the financial system's stability. This study contributes valuable insights for policymakers and financial institutions aiming to bolster Indonesia's financial stability through prudent macroeconomic management and the strategic implementation of financial inclusion initiatives.

This paper challenges monetary policy after the financial crisis. The discussion shows that forward guidance of theinterest rate and Quantitative Easing (QE) may give monetary policy more power when the short term nominalinterest rate is close to zero lower bound. The current recession is a consequence of excessive debt in private andpublic sector, and since both public and household sector need time to pay down debts and rebuild savings, standardmonetary policy as well as non-standard monetary policy (QE) will have limited effects on the present recession. Animportant lesson from financial crisis is that imbalances in the financial sector and high debt in private and publicsector may fly under the inflation radar screen in conventional monetary policy and undermine the economy.Monetary policy in future should therefore target also financial stability. Taylor’s rule affords a monetary policy withmaximum of transparency, but it is unlikely to perform better than a central bank’s carefully judgment of inflation,production gap, other possible targets, and the means that the bank has available (the interest rate). The Tinbergenrule tells us that we need one instrument for every independent target, and monetary policy therefore needs help fromother economic policy areas. Even if we need an independent central bank, the central bank must also communicateand cooperate with government. Finely, the paper suggests that one should use market mechanisms to a higherdegree in the bank market to make clear to lending institutions that they are responsible and must consider the risk inrelation to their investments.