The Interaction of Monetary Policy and Financial Stability: Lessons from the 2007 Crisis

Abstract

The financial crisis motivated thinking about interaction between financial and monetary stability policies. These policies are more interrelated than previously thought. The purpose of the paper is to develop an analytical framework that analyzes these interactions. We use an overlapping-generations model in which an aggregate financial risk is endogenous. It embeds negative externalities in the perceived risk, and integrates banking into our DSGE model. The results include (i) monetary policy's effectiveness is affected by financial stability policy; (ii) institutional constraints on central bank's lending affect the operation of monetary policy transmission mechanism; (iii) policy makers will conceivably face tradeoffs between price stability and financial stability.

Keywords: Inflation target, Financial stability, Monetary policy transmission mechanism, Aggregate financial risk

JEL Classification: E5