Monetary Policy and Financial (In)Stability: An Integrated Micro-Macro Approach
Ferre De Graeve
Thomas K. Kick
Frankfurt School of Finance and Management
Central banks focus on two objectives today: monetary and financial stability. Empirical evidence on this twin objective is scarce. We aim to contribute on the issue with an integrated micro-macro approach with two core virtues. First, we measure financial stability at the bank level for Europe's largest economy: Germany. Second, we specify a VAR model with feedback between the micro- and macroeconomic model components. This enables us to assess second round effects. Our results confirm the existence of a trade-off between monetary and financial stability. An unexpected tightening of monetary policy increases the mean probability of distress. This effect disappears when neglecting feedback effects, underlining the crucial importance of the former. Distress responses differ across banking groups and the severity of distress events. Hence, a more detailed account of heterogenous transmission dynamics beyond aggregate measures of financial stability is corroborated. An important policy implication is that the separation of financial supervision and monetary policy requires close collaboration among members in the European System of Central Banks and other national supervision authorities.
Number of Pages in PDF File: 24
Keywords: financial stability, stress testing, bank distress, monetary policy
JEL Classification: E42, E52, E58, G21, G28working papers series
Date posted: February 28, 2007
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