Financial Instabilities and Risk Management by Central Banks

Abstract

Among the various shocks that may cause financial instabilities, the bursting of asset bubbles has received most attention during the last decade. This paper discusses the risk management of financial instabilities caused by asset price crashes and evaluates the appropriate role of central banks. After an asset bubble crashes, central banks typically ease monetary policy to dampen the negative impact of the bust on economic activity. In this paper we address the question of why central bankers behave asymmetrically. Our answer to this question has three parts. First, simulations of theoretical models which include bubbles give an ambiguous answer as to whether or not central banks should try to target asset prices along with inflation and the output gap. Second, the historical episodes of asset price booms and busts suggest that using restrictive monetary policy to dampen bubbles may not work and in addition may destabilize the economy. Finally the central bankers are likely to be politically prevented from increasing interest rates solely to deflate an asset price boom. The paper also reviews the recent subprime mortgage crisis that was partially caused by the bursting of the housing bubble to emphasize the wide range of financial instability episodes that are included in the risk management responsibilities of central banks.

JEL Classification: E50, E52, E58