Monetary Policy, Private Debt and Financial Stability Risks

36 Pages Posted: 14 Nov 2016

See all articles by Gregory H. Bauer

Gregory H. Bauer

University of Rochester - Simon School

Eleonora Granziera

Bank of Finland

Date Written: November 11, 2016

Abstract

Can monetary policy be used to promote financial stability? We answer this question by estimating the impact of a monetary policy shock on private-sector leverage and the likelihood of a financial crisis. Impulse responses obtained from a panel VAR of eighteen advanced countries suggest that the debt-to-GDP ratio rises in the short run following an unexpected tightening in monetary policy. As a consequence, the likelihood of a financial crisis increases, as estimated from a panel logit regression. However, in the long run, output recovers and higher borrowing costs discourage new lending, leading to a deleveraging of the private sector. A lower debt-to-GDP ratio in turn reduces the likelihood of a financial crisis. These results suggest that monetary policy can achieve a less risky financial system in the long run but could fuel financial instability in the short run. We also find that the ultimate effects of a monetary policy tightening on the probability of a financial crisis depend on the leverage of the private sector: the higher the initial value of the debt-to-GDP ratio, the more beneficial the monetary policy intervention in the long run, but the more destabilizing in the short run.

Keywords: Monetary Policy, Financial Stability, Financial Crises, Panel Logit, Structural Vector Autoregressions, Sign Restrictions

JEL Classification: E; E52, E58, C21, C23

Suggested Citation

Bauer, Gregory H. and Granziera, Eleonora, Monetary Policy, Private Debt and Financial Stability Risks (November 11, 2016). Available at SSRN: https://ssrn.com/abstract=2869044 or http://dx.doi.org/10.2139/ssrn.2869044

Gregory H. Bauer

University of Rochester - Simon School ( email )

Rochester, NY 14627-0107
United States

Eleonora Granziera (Contact Author)

Bank of Finland ( email )

Snellmaninaukio
Helsinki, Helsinki 00100
Finland

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

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