Abstract
Abstract The extensive harm caused by the financial crisis raises the question of whether policymakers could have done more to prevent the build-up of financial imbalances. This paper aims to contribute to the field of regulatory impact assessment by taking up the revived debate on whether central banks should use the interest rate to directly respond to the build-up of financial sector imbalances, i.e. ‘lean against the wind’ or not. Currently, there is no consensus on whether monetary policy is, in general, able to support the resilience of the financial system or if this task should better be left to the macroprudential approach of financial regulation. The author aims to shed light on this issue by analyzing distinct policy regimes within an agent-based computational macro-model with endogenous money. He finds that policies that make use of their comparative advantage lead to superior outcomes concerning their respective intended objectives. In particular, he shows that ‘leaning against the wind’ should only serve as first line of defense in the absence of a prudential regulatory regime and that price stability does not necessarily mean financial stability. Moreover, macroprudential regulation as unburdened policy instrument is able to dampen the build-up of financial imbalances by restricting credit to the unsustainable high-leveraged part of the real economy.
Highlights
In a competitive environment, banks’ private choices concerning money creation are not socially optimal burdening the economy with externalities and leaving the system vulnerable to financial crises
The focus more and more turned from crisis mitigation towards the current dual mandate since it was generally agreed that inflation represents one of the main sources of financial instability and that achieving price stability would be sufficient to ensure financial stability [Schwartz (1995)]
The results show that without an active guidance of economic activity through monetary policy, financial stability cannot be achieved, i.e. losses for δπ ≈ 1.25 significantly increase the fragility of the system which underpins the above mentioned common view that inflation can be seen as one of the main sources of financial instability
Summary
Banks’ private choices concerning money creation are not socially optimal burdening the economy with externalities and leaving the system vulnerable to financial crises. In this context, the focus is on “how to exploit the magic of credit for growth without inciting banks to imprudent lending practices”, as Giannini (2011) puts it, and how to avoid states of the financial system which are macroeconomically destructive instead of growth-supportive. The corresponding debate is mainly on whether to continue to entirely rely on financial regulation and macroprudential policy instruments [Hanson et al (2011); Criste and Lupu (2014); Tomuleasa (2015)] to ensure financial stability or to respond directly to financial imbalances through monetary policy
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