Securing financial stability: What role for monetary policy?

From: Blog

The Global Financial Crisis (GFC) of 2007-09 has compelled central bankers to reconsider the role of monetary policy in securing financial stability. In his excellent opening speech at the Asian Monetary Policy Forum (AMPF), Ravi Menon describes three approaches to this issue: 

1. Stick to the pre-GFC approach to monetary policy and its focus on price stability. Supplement monetary policy with traditional prudential regulations such as capital requirements for financial institutions. 

2. Explicitly incorporate financial stability concerns into the conduct of monetary policy, tightening, for example, in response to an unsustainable credit boom.

3. Retain focus on price stability in the conduct of monetary policy, but deploy a range of macroprudential tools to secure financial stability.

The first approach still prevails at most central banks, especially in advanced economies, but policymakers now pay more attention to financial stability concerns.

The second approach rests on the insight that monetary policy affects financial stability through the risk-taking channel. "Loose monetary policy can heighten vulnerabilities in the financial system" by lowering risk premiums, thereby promoting risk-taking activities and encouraging banks to expand credit. Conversely, tight monetary policy raises risk premiums, discouraging risk-taking behavior and restraining credit growth.

An appealing feature of the second approach, as Menon explains, is that monetary policy can "get in all the cracks" of the financial system. Financial institutions cannot easily evade the effects of tight monetary policy the way they often work around restrictive regulations. Also, the second approach requires only modest departures from well-established and well-understood monetary policy practices. Operationally, the approach amounts to augmenting the Taylor Rule so that financial stability concerns influence the central bank's choice of its policy rate.

Menon also explains why relying on monetary policy to secure financial stability may not be enough. First, the policy rate that promotes financial stability may differ from the rate needed for price and output stability. Second, global financial forces may constrain the conduct of monetary policy, an especially important factor for many emerging market economies. Third, although monetary policy can get in all the cracks, it may not be sufficiently potent to fully address serious threats to financial stability. 

These limitations of monetary policy lead central banks to consider, and sometimes use, a range of macroprudential policy tools. I will have more to say on that topic in the next post. 

—Steven J. Davis


Steven J. Davis is William H. Abbott Professor of International Business and Economics and deputy dean of the faculty at the University of Chicago Booth School of Business. 


Eight days of Hanukkah and good intentions

From: Blog

As Hanukkah approaches, people can start feeling a little more in touch with their beliefs. But there’s a pattern that can emerge even when we’re in the midst of “projects” that mean a lot to us personally – like the eight days of Hanukkah. We dive in to undertakings teeming with energy and good intentions, but after a while we can fade. But when there’s finally light at the end of the tunnel, we get recharged and bring it home in a big way. This pattern—slacking in the middle—is fairly common, but what’s interesting is that not only does the quality of our work fade in the middle of a long work project, but our personal beliefs can go on a temporary vacation as well.

Chicago Booth professor Ayelet Fishbach and her former student, Maferima Touré-Tillery, set out to see how people’s performance, along with their ethical and religious standards, vary across a series of tasks.

In one experiment, the team had participants flip coins to determine whether they proofread long or short passages. Chance would predict an equal distribution of long and short passages across all 10 trials—and there was, at the beginning and end of the tasks. But oddly, in the middle, short passages were landed on 70% of the time, which suggests that the participants might have been assisting the flipping process a bit.

The same pattern of results was observed when it came to cutting out a series of shapes and to receiving undue credit for their work. Even when the researchers tested participants who were strongly religious, they found that the participants were more likely to light Hanukkah candles at the beginning and end of the eight nights, and less likely to do so in the middle.

Fishbach and Touré-Tillery think that this effect has to do with how we determine cost-benefit ratios over time, so that it somehow doesn’t seem so bad when we relax our own standards—even ethical or religions ones—in the middle of a project.

This may be because we feel that the beginning and the end are more indicative of our own beliefs about ourselves. “People believe that these actions at the beginning and the end are more telling of who they really are,” said Fishbach. “So they pay closer attention to act the way they want to see themselves.” If you’re having a hard time getting through the middle of a project, don’t beat yourself up too much—it seems to be just a part of being human. And being aware of it may help you stay a bit more energized through that long middle stretch. 
—Alice G. Walton 
Cat:More,Sub:Behavioral Science,