Macroprudential policy – closing the financial stability gap
| Published date | 13 November 2017 |
| Pages | 334-359 |
| DOI | https://doi.org/10.1108/JFRC-03-2017-0037 |
| Date | 13 November 2017 |
| Author | Stephan Fahr,John Fell |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial compliance/regulation |
Macroprudential policy –closing
the financial stability gap
Stephan Fahr and John Fell
DG-Macroprudential Policy and Financial Stability, European Central Bank,
Frankfurt am Main, Germany
Abstract
Purpose –The global financial crisis demonstrated that monetary policy alone cannot ensure bothprice
and financialstability. According to the Tinbergen (1952) rule, there was a gap in the policymakers’toolkitfor
safeguardingfinancial stability, as the number of available policy instruments was insufficientrelative to the
number of policyobjectives. That gap is now being closed through the creationof new macroprudential policy
instruments. Both monetarypolicy and macroprudential policy have the capacity to influence both priceand
financial stability objectives. This paper develops a framework for determining how best to assign
instrumentsto objectives.
Design/methodology/approach –Using a simplified New-Keynesianmodel, the authors examine two
sets of policy trade-offs,the first concerning the relative effectivenessof monetary and macroprudential policy
instrumentsin achieving price and financial stability objectives andthe second concerning trade-offs between
macroprudentialpolicy instruments themselves.
Findings –This model shows that regardless of whether the objective is to enhance financial system
resilienceor to moderate the financialcycle, macroprudential policies aremore effective than monetary policy.
Likewise, monetary policy is more effective than macroprudential policy in achieving price stability.
According to the Mundell(1962) principle of effective market classification,this implies that macroprudential
policy instruments should be paired with financial stability objectives, and monetary policy instruments
should be paired with theprice stability objective. The authors also find a trade-offbetween the two sets of
macroprudentialpolicy instruments, which indicates that failureto moderatethe financial cycle would require
greater financialsystem resilience.
Originality/value –The main contribution of the paper is to establish –with the help of a model
framework –the relative effectiveness of monetary and macroprudential policies in achieving price and
financial stabilityobjectives. By so doing, it provides a rationalefor macroprudential policy and it shows how
macroprudentialpolicy can unburden monetary policyin leaning against the wind of financial imbalances.
Keywords Financial stability, Monetary policy, Systemic risk, Macroprudential policy,
Policy assignment, Tinbergen rule
Paper type Research paper
Corrigendum
It has been brought to Emerald’s attention that the article“Macroprudential policy –closing
the financial stability gap”by StephanFahr and John Fell, published in Journal of Financial
Regulation and Compliance,Vol. 25 No. 4 2017, includes two errors.
(1) The denominator in the first line of equation 8 on p. 344 incorrectly omitted “
s
1
+”.The
expression should thus read:
The views and opinions expressed in this article are those of the authors and do not necessarily
reflect those of the European Central Bank or its Governing Council. The authors would like to thank
Pablo Aguilar, Richard Barwell, Markus Behn, Frank Smets, Matija Lozej, Dirk Schoenmaker and
Frank Smets for fruitful discussions and comments.
JFRC
25,4
334
Journalof Financial Regulation
andCompliance
Vol.25 No. 4, 2017
pp. 334-359
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-03-2017-0037
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
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(2) Furthermore, in the last equation on page 353, the boundaries of the sum had been
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This has been corrected in the online version.The authors apologise for these errors.
Stylistic errors, including label andaxis alignment have also been corrected in Figures 1 and 2.
1. Monetary policy and macroprudential policy: two distinct policy domains
for the macroeconomy
1.1 The financial crisis has shown monetary policy to be insufficient to ensure financial
stability
An important policy lesson of the global financial crisis that erupted in 2008 was that the
attainment of price stability is insufficient for ensuring financial stability. The inordinately
large costs of the crisis challenged the “Jackson Hole consensus”, the prevailing orthodoxy
which held that central bankers’maintaskistokeepinflation low and stable and that
monetary policy should not attempt to counteract asset price booms (Bean et al.,2010;
Issing, 2011;Mishkin, 2010;White, 2009). In so doing, it reopened the so-called “leaning”
versus “cleaning”debate,that is, the question of whether it is less costlyfor a central bank to
take measures which prevent financial crises or, instead, to respond by cleaning up after a
crisis has materialised,with the Jackson Hole consensus favouring the latter approach.
As Borio (2012) explains, one of the analytical implications of the global financial crisis was a
rediscovery of the notion of financial cycles which had been prominent in the writings of
Kindleberger (1978) and Minsky (1977). While there is no commonly accepted definition of what
constitutes a financial cycle, it is generally taken to mean the endogenous cycles in perceptions of
financial risk that begin with episodes of financial exuberance, leading to financial imbalances
and, eventually, to a so-called Minsky moment where there is a sudden and major collapse of
asset values that leads to a financial crisis[1]. With its rediscovery, a new objective for
policymakers of taming the financial cycle emerged (Barwell, 2013). The challenge for
policymakers has been to identifytheinstrumentsthatarebestsuitedtothistask.Thereare
several reasons why great caution should be exercised in using monetary policy instruments to
moderate the financial cycle, two of which have been made clear by the crisis.
First, financial cycles are distinctfrom, longer in duration and greater in amplitude than
business cycles (Borio and Drehmann,2009;Claessens et al.,2011,2014;Schüler et al.,2015).
These different cyclical features create potential for desynchronisation between business
and financial cycles so thatmonetary policy instruments will be insufficient to achieveprice
and financial stability objectivesat all times. Figure 1 illustrates this for a stylised situation
where the financial cycle has double the duration and doublethe amplitude of the business
cycle, while, for simplicity, both cycles have the same phase (i.e. the point of the cycle at
t=0)[2]. Consider the region between B and C, a situation where the business cycle is
contracting (i.e. output is below potential) while the financial cycle is above neutral, such
that financial imbalancesare building up, a conflict of objectives inevitably arises if the only
policy instrument available is the interest rate: an increase of interest rates aimed at
Closing the
financial
stability gap
335
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