Financial Stability and Monetary Policy: How Closely Interlinked?
by Frank Smets
European Central Bank
The recent financial crisis has again raised the question
to what extent price-stability-oriented monetary policy frameworks
should take into account financial stability objectives.
In this paper I argue that the answer will depend on three
questions: (i) how effective is macroprudential policy in maintaining
financial stability? (ii) what is the effect of monetary
policy on risk taking and financial stability? and (iii) what is
the risk of financial dominance, i.e., the risk that financial stability
considerations undermine the credibility of the central
bank’s price stability mandate? I review the theory and evidence
and conclude that while the new macroprudential policy
framework should be the main tool for maintaining financial
stability, monetary policy authorities should also keep an eye
on financial stability. This will allow the central bank to lean
against the wind if necessary, while maintaining its primary
focus on price stability over the medium term.
JEL Codes: E58, G28.
Full article (PDF, 38 pages, 307 kb)