Monetary Policy, Financial Conditions, and Financial Stability
by Tobias Adriana and Nellie Liangb
We review a growing literature that incorporates endogenous
risk premiums and risk-taking in the conduct of monetary
policy. Accommodative policy can create an intertemporal
tradeoff between improving current financial conditions
at a cost of increasing future financial vulnerabilities. In the
United States, structural and cyclical macroprudential tools
to reduce vulnerabilities at banks are being implemented, but
may not be sufficient because activities can migrate and there
are limited tools for non-bank intermediaries or for borrowers.
While monetary policy itself can influence vulnerabilities, its
efficacy as a tool will depend on the costs of tighter policy on
activity and inflation. We highlight how adding a risk-taking
channel to traditional transmission channels could significantly
alter a cost-benefit calculation for using monetary policy, and
that considering risks to financial stability—as downside risks
to employment—is consistent with the dual mandate.
JEL Codes: E44, E52, E58, G21, G28.
Full article (PDF, 59 pages, 796 kb)
a International Monetary Fund
b Brookings Institution