Monetary Tightening, Quantitative Easing, and Financial Stability

Abstract

This paper analyses the implications of central bank balance sheet policies on financial stability in a framework with banks facing occasionally-binding leverage constraints and endogenous disruptions in financial intermediation. Whilst central bank balance sheet expansions are effective in stabilising the economy in a financial stress episode, they increase the likelihood of such episodes and their duration. Balance sheet expansions induce financial intermediaries to take on more risk and slow their recapitalisation during a stress episode. In a tightening cycle, stabilisation properties of balance sheet policies are maintained but come at a significant cost to price stability.

Keywords: Quantitative easing, financial stability, monetary policy, financial crises