June 2013 issue contents
Like a Good Neighbor: Monetary Policy, Financial Stability, and the Distribution of Risk

by Evan F. Koenig
Federal Reserve Bank of Dallas and Southern Methodist University


In an economy in which debt obligations are fixed in nominal terms, a monetary policy focused narrowly on controlling inflation insulates lenders from aggregate output risk, leaving borrowers as residual claimants. This concentration of risk has the potential to exacerbate the financial distress associated with adverse supply shocks. A better risk distribution is obtained if the price level is allowed to rise whenever output is unexpectedly weak. Illustrative examples are presented in which an appropriately countercyclical inflation policy exactly reproduces the risk allocation that one would observe with perfect capital markets.

JEL Codes: E52, E44, G10.

Full article (PDF, 26 pages 273 kb)

Discussion by Klaus Schmidt-Hebbel