Monetary policy and financial stability

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 strategies for an economy that experiences endogenous financial crises due to excessive household sector leverage. We reach three 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, 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.