Monetary Policy and Financial Stability: Is Inflation Targeting Passé?
University of Tokyo - Faculty of Economics; National Bureau of Economic Research (NBER); Ministry of Finance, Tokyo
July 1, 2010
Asian Development Bank Economics Working Paper Series No. 206
It would be easy to say that central banks should consider asset prices as one of the objectives to avoid boom and bust cycles, as happened in the 2007-2009 crisis; the dotcom bubble of 2001; and the Japanese boom and bust of the 1980s and 1990s. However, its implementation would be theoretically and empirically difficult since the monetary policy instrument, narrowly defined, is just the interest rate. Flexible inflation targeting (FIT) is basically a sound monetary policy framework even after experiencing a severe financial crisis, as what originated in the United States. Assigning too much weight to asset prices as a monetary policy objective would cause a serious tradeoff problem. Consumer price index deflation may have to be tolerated to avoid an asset bubble, which would be a serious problem, since once a bubble is formed, a slight increase in the interest rate would not stop it. The first-best policy is to enhance supervision and regulation of financial institutions to avoid moral hazard and concentration of risk.
Number of Pages in PDF File: 26
JEL Classification: E31, E52, E58working papers series
Date posted: August 2, 2010
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