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A Quantitative Case for Leaning Against the Wind

44 Pages Posted: 15 Dec 2016  

Andrew J. Filardo

Bank for International Settlements (BIS) - Monetary and Economic Department

Phurichai Rungcharoenkitkul

Bank for International Settlements (BIS) - Monetary and Economic Department; Bank of Thailand

Date Written: December 2016

Abstract

Should a monetary authority lean against the build-up of financial imbalances? We study this policy question in an environment in which there are recurring cycles of financial imbalances that develop over time and eventually collapse in a costly manner. The optimal policy reflects the trade-off between the short-run macroeconomic costs of leaning against the wind and the longer-run benefits of stabilising the financial cycle. We model the financial cycle as a nonlinear Markov regime-switching process, calibrate the model to US data and characterise the optimal monetary policy. Leaning systematically over the whole financial cycle is found to outperform policies of "benign neglect" and "late-in-the-cycle" discretionary interventions. This conclusion is robust to a wide range of alternative assumptions and supports an orientation shift in monetary policy frameworks away from narrow price stability to a joint consideration of price and financial stability.

Keywords: monetary policy, financial stability, leaning against the wind, financial cycle, time-varying transition probability Markov regime-switching model

JEL Classification: E52, E58, E32, E37

Suggested Citation

Filardo, Andrew J. and Rungcharoenkitkul, Phurichai, A Quantitative Case for Leaning Against the Wind (December 2016). BIS Working Paper No. 594. Available at SSRN: https://ssrn.com/abstract=2883403

Andrew Filardo (Contact Author)

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Phurichai Rungcharoenkitkul

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Bank of Thailand ( email )

273 Samsen Road
Bangkhunprom, Bangkok 10200
United States

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