Monetary Policy and Financial Stability

Posted: 13 Jul 2021

See all articles by Isabel Cairo

Isabel Cairo

Board of Governors of the Federal Reserve System

Jae Sim

Board of Governors of the Federal Reserve System

Date Written: December, 2020

Abstract

The 2008 Global Financial Crisis called into question the narrow focus on price stability of inflation targeting regimes. This paper studies the relationship between price stability and financial stability by analyzing alternative monetary policy regimes for an economy that experiences endogenous financial crises due to excessive household sector leverage. We reach four conclusions. First, a central bank can improve both price stability and financial stability by adopting an aggressive inflation targeting regime, in the absence of the zero lower bound (ZLB) constraint on nominal interest rates. Second, in the presence of the ZLB constraint, an aggressive inflation targeting regime may undermine both price stability and financial stability. Third, an aggressive price-level targeting regime can improve both price stability and financial stability, regardless of the presence of the ZLB constraint. Finally, a leaning against the wind policy can be detrimental to both price stability and financial stability when the credit cycle is driven by countercyclical household sector leverage. In this environment, leaning with credit spreads can be more effective.

JEL Classification: E32, E52, G01

Suggested Citation

Cairo, Isabel and Sim, Jae W., Monetary Policy and Financial Stability (December, 2020). FEDS Working Paper No. 2020-101, Available at SSRN: https://ssrn.com/abstract=3865400 or http://dx.doi.org/10.17016/FEDS.2020.101

Isabel Cairo (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Jae W. Sim

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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