Trade-offs between macroeconomic and financial stability objectives

The current global economic environment is putting central bankers in Europe and other advanced economies to the test. What should be the appropriate monetary policy stance when economic growth is sluggish, inflation is below the target, but at same time financial stability risks are on the rise? Should central banks be concerned about financial stability risks in addition to their macroeconomic stability objective? Trade-offs that central banks may face remain at the heart of policy discussions. Using a New Keynesian three-equation model upgraded to include an endogenous asset price bubble, we contribute to this discussion by assessing trade-offs between the objectives of price, output and financial stability, when the central bank attempts to actively respond to financial stability risks. We find that a “leaning against the wind” policy cannot simultaneously achieve macroeconomic and financial stability, in case of supply or assets price bubble shocks.