Does Easing Monetary Policy Increase Financial Instability?

47 Pages Posted: 12 Dec 2015

See all articles by Ambrogio Cesa-Bianchi

Ambrogio Cesa-Bianchi

Bank of England

Alessandro Rebucci

Johns Hopkins University - Carey Business School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 6 versions of this paper

Date Written: December 11, 2015

Abstract

This paper develops a model featuring both a macroeconomic and a financial friction that speaks to the interaction between monetary and macroprudential policy and to the role of US monetary and regulatory policy in the run up to the Great Recession. There are two main results. First, real interest rate rigidities in a monopolistic banking system increase the probability of a financial crisis (relative to the case of flexible interest rate) in response to contractionary shocks to the economy, while they act as automatic macroprudential stabilizers in response to expansionary shocks. Second, when the interest rate is the only available policy instrument, a monetary authority subject to the same constraints as private agents cannot always achieve a (constrained) efficient allocation and faces a trade-off between macroeconomic and financial stability in response to contractionary shocks. An implication of our analysis is that the weak link in the US policy framework in the run up to the Global Recession was not excessively lax monetary policy after 2002, but rather the absence of an effective second policy instrument aimed at preserving financial stability.

Keywords: Macroprudential policies, monetary policy, financial crises, frictions, interest rate

JEL Classification: E44, E52, E61

Suggested Citation

Cesa-Bianchi, Ambrogio and Rebucci, Alessandro, Does Easing Monetary Policy Increase Financial Instability? (December 11, 2015). Bank of England Working Paper No. 570. Available at SSRN: https://ssrn.com/abstract=2702438 or http://dx.doi.org/10.2139/ssrn.2702438

Ambrogio Cesa-Bianchi (Contact Author)

Bank of England ( email )

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HOME PAGE: http://https://sites.google.com/site/ambropo/

Alessandro Rebucci

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

HOME PAGE: http://carey.jhu.edu/faculty-research/faculty-directory/alessandro-rebucci-phd

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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