Discussion Paper Details

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Title: Monetary Policy, Financial Conditions, and Financial Stability

Author(s): Tobias Adrian and Nellie Liang

Publication Date: July 2016

Keyword(s): financial conditions, financial stability, leaning against the wind, macroprudential policy, monetary policy rules, monetary policy transmission and risk taking channel of monetary policy

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

Abstract: We review a growing literature that incorporates endogenous risk premiums and risk taking in the conduct of monetary policy. Accommodative policy can create an inter-temporal tradeoff between improving current financial conditions at a cost of increasing future financial vulnerabilities. In the U.S., 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 nonbank 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.

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Bibliographic Reference

Adrian, T and Liang, N. 2016. 'Monetary Policy, Financial Conditions, and Financial Stability'. London, Centre for Economic Policy Research.