Grasping Reality on TypePad, by Brad DeLong

Outline

• What can monetary policy achieve?
  • Do not ask to much from monetary policy
• What is the relation between monetary policy and financial stability?
  • Monetary policy and financial-stability policy are very different
  • In normal times: Best conducted separately, also when conducted by the same institution
  • But each policy should be fully informed about and take into account the conduct of the other policy
  • In crisis times: Full cooperation between the relevant authorities
  • Monetary policy should be the very last line of defense of financial stability, not to be used in normal times  What can – and cannot - monetary policy achieve?
• MP can stabilize inflation around a given inflation target
• MP can stabilize overall resource utilization around a long-run sustainable rate
  • But the latter is determined by nonmonetary, structural factors
• MP cannot affect the long-run sustainable rate of resource utilization
  • This requires structural policies
• MP cannot solve structural problems
  • This requires structural policies

What can – and cannot - monetary policy achieve?

• MP cannot achieve financial stability
  • This requires financial-stability policy (macroprudential policy)
• Leaning against the wind cannot solve debt problems
  • See Riksbank bad example (FT Big Read Nov 20)
  • In Swedish case, benefits of leaning are just around 0.4% of costs (should have be more than 100% of costs to justify policy)
• Inherent flaw in leaning
  • Running inflation below a credible inflation target increases households’ and other agents’ real debt burden
  • It also increases unemployment

What can – and cannot - monetary policy achieve?

• Do not ask too much of monetary policy  What is the relation between monetary policy and financial stability?

• Distinguish economic policies according to:

  • (1) objectives,
  • (2) suitable instruments, and
  • (3) responsible authorities
• MP and financial-stability policy (FSP) are clearly separate policies, with different objectives and different suitable instruments, regardless of whether they have the same or different responsible authorities

Monetary policy

• Objective
  • Flexible inflation targeting: Price stability and real stability
• Instruments
  • Normal times: Policy rate, communication
  • Crisis times: Also unconventional measures, balance sheet policies, FX policy, ...

• Responsible authority

  • Centralbank  Financial-stability policy

• Objective

  • Financial stability: Financial system fulfilling 3 main functions w/ sufficient resilience to disturbances that threaten those functions
• Instruments
  • Normaltimes:Regulation,supervision,macroprudentialpolicy, buffers, capital requirements, LTV caps, LCRs, NSFRs, taxes, deposit insurance, ...
  • Crisis times: Lending of last resort, liquidity support, capital injections, guarantees, banking resolution, ...

• Authority(ies)

  • Varies across countries
  • FSA, CB, banking-resolution authority, MoF, ...  What is the relation between monetary policy and financial-stability policy?

• Very different policies

• In normal times: Conduct independently, also when conducted by the same authority
  • Each policy should be fully informed about and take into account the conduct of the other’s policy
  • Similar to MP and fiscal policy (Nash equilibrium rather than coordinated equilibrium (joint optimization)

• In crisis times: Full cooperation and joint policies by FSA, CB, MoF, banking-resolution authority...  Monetary policy's best contribution to financial stability?

• Inflation on target and resource utilization at long-run sustainable rate

• Suppose 2% inflation and 3% real growth, nominal growth 5% of asset prices and disposable income, doubling every 14 years
• For any given nominal debt, LTV and DTI ratios halved in 14 years. Pretty good for repair of balance sheets.
• Monetary policy should only be the very last line of defense of financial stability, normally not to be used

Svensson.pdf