Monetary policy impacts financial stability – BIS paper

Monetary policy influences the build-up of financial imbalances, and a policy of “leaning against” booms could boost welfare, research published by the Bank for International Settlements finds.

Authors Frederic Boissay, Fabrice Collard, Jordi Galí and Cristina Manea augment a “textbook” New Keynesian macroeconomic model with mechanisms that generate financial imbalances.

The paper outlines a model featuring “endogenous capital accumulation”, meaning the economy can deviate from its steady state, the authors say. Firms face idiosyncratic productivity shocks, leading to capital reallocation via a credit market. Financial frictions make the credit market “fragile”.

The model ignores macro-prudential policy, which the authors acknowledge as having “potential complementarities” with monetary policy. But they say an “important advantage” of their approach is that it allows them to isolate the effect of monetary policy on financial stability.

The authors find monetary policy affects financial stability in the short run, through its effects on aggregate demand and markups, and in the medium run, through its effects on capital accumulation.

“We also show that, by deviating from strict inflation targeting and systematically leaning against investment booms, the central bank may not only reduce the probability of a crisis but also improve welfare,” they say.

Finally, a central bank risks triggering a crisis by holding policy too loose for too long, and then “unexpectedly and abruptly” raising rates to tackle a boom, the authors say.