Another lesson learnt from the financial crisis is that monetary policy and financial stability policy are intrinsically linked to each other and so the dichotomy between monetary and financial stability policy is a false one. As we have seen,monetary policy can affect financial stability, while macro-prudential policies to promote financial stability will have an impact on monetary policy. If macro-prudential policies are implemented to restrain a credit bubble, they will slow credit growth and will slow the growth of aggregate demand. In this case, monetary policy may need to be easier in order to offset weaker aggregate demand. Alternatively, if policy rates are kept low to stimulate the economy, as is true currently, there is a greater risk that a credit bubble might occur. This may require tighter macro-prudential policies to ensure that a credit bubble does not get started.
Coordination of monetary and macro-prudential policies becomes of greater value when all three objectives of price stability, output stability and financial stability are to be pursued. The recent financial crisis provides strong support for a systemic regulator and that central banks are the natural choice for this role. The benefits of coordination between monetary policy and macro-prudential policy provide another reason for having central banks take on the systemic regulator role. Coordination of monetary policy and macro-prudential policy can only be effective if one government agency is in charge of both. As anyone who has had the pleasure of experiencing the turf battles of different government agencies knows, coordination of policies is extremely difficult when control of these policies is housed in different entities.
The recent financial crisis, however, does require some major rethinking about the details of this basic framework for monetary policy strategy. We now recognize that the financial sector play a very prominent role in the macro economy and makes it highly nonlinear at times. This requires that we abandon the linear-quadratic framework for thinking about how to conduct monetary policy when there is a financial disruption. There is now a stronger case for a risk management framework that factors in tail risks that can produce very adverse outcomes for the economy. Another lesson is that there is a stronger case for monetary policy to lean against credit bubbles (but not asset-price bubbles per se), rather than just cleaning up after the bubble has burst. Using monetary policy to pursue financial stability goals is not an easy task, however, and research on how to monitor credit conditions so that its decisions to use monetary policy to restrict excessive risk are based on the correct information will be a high priority for research in the future. Finally, the financial crisis has made it clear that the interactions between the financial sector and the aggregate economy imply that monetary policy and financial stability policy are closely intertwined.
