Monetary Policy and Financial Stability: In Search of Trade-offs

In the aftermath of the 2008 global financial crisis, it has been argued that monetary policy should prevent raising financial risk by responding actively to financial imbalances. This paper investigates the extent to which a central bank’s reaction to financial instability may be incompatible with its other macroeconomic stability objectives. The analytical framework relies on a New Keynesian model with an endogenous financial bubble, where it is assumed that tightening monetary policy can dampen raising financial risk. The paper concludes that a leaning against the wind strategy can generate trade-offs between the traditional inflation-output stability and financial stability objectives.