DP11394 Monetary Policy, Financial Conditions, and Financial Stability

Author(s): Tobias Adrian, Nellie Liang
Publication Date: July 2016
Keyword(s): financial conditions, financial stability, leaning against the wind, macroprudential policy, monetary policy rules, monetary policy transmission, risk taking channel of monetary policy
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11394

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√Ę??as downside risks to employment--is consistent with the dual mandate.