Does Easing Monetary Policy Increase Financial Instability?

JEL codes: 
E44, E52, E61
Version Date: 
Jan 2013

We develop a model featuring both a macroeconomic and a financial stability objective that speaks to the interaction between monetary and macro-prudential policies. First, we find that interest rate rigidities in a monopolistic banking system have an asymmetric impact on financial stability: they exacerbate the effects of financial frictions in response to contractionary shocks to the economy, while they act as an automatic stabilizer in response to expansionary shocks. Second, when the policy interest rate is the only available instrument, a monetary authority subject to the same constraints as those of private agents cannot always achieve a (constrained) efficient allocation and faces a trade-off between macroeconomic and financial stability in response to negative shocks. This has important implications for the role played by U.S. monetary policy in the run up to the global financial crisis. Our model suggests that the weak link in the U.S. policy framework was not an excessively lax monetary policy stance after 2002, but rather the absence of an effective second policy instrument aimed at preserving financial stability.

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