Financial Instabilities and Risk Management by Central Banks

Posted: 27 Aug 2008

See all articles by Marc D. Hayford

Marc D. Hayford

Loyola University of Chicago - Department of Economics

A. (Tassos) G. Malliaris

Loyola University of Chicago - Department of Economics

Date Written: August 25, 2008

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

Suggested Citation

Hayford, Marc D. and Malliaris, A. (Tassos) G., Financial Instabilities and Risk Management by Central Banks (August 25, 2008). Available at SSRN: https://ssrn.com/abstract=1257202 or http://dx.doi.org/10.2139/ssrn.1257202

Marc D. Hayford

Loyola University of Chicago - Department of Economics ( email )

820 N. Michigan Ave.
Chicago, IL 60611
United States
312-915-6062 (Phone)
312-915-8508 (Fax)

A. (Tassos) G. Malliaris (Contact Author)

Loyola University of Chicago - Department of Economics ( email )

16 E. Pearson Ave
Quinlan School of Business
Chicago, IL 60611
United States
312-915-6063 (Phone)

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