MONETARY POLICY AND FINANCIAL STABILITY 
     September 2015 
                             IMF staff regularly produces papers proposing new IMF policies, exploring options for 
                             reform, or reviewing existing IMF policies and operations. The following document(s) 
                             have been released and are included in this package: 
                            The Staff Report prepared by IMF staff and completed on August 28, 2015.
                             Informal Session to Engage: 
                               The report prepared by IMF staff has benefited from comments and suggestions by 
                               Executive Directors following the informal session on September 14, 2015. Such 
                               informal sessions are used to brief Executive Directors on policy issues and to receive 
                               feedback from them in preparation for a formal consideration at a future date. No 
                               decisions are taken at these informal sessions. The views expressed in this paper are 
                               those of the IMF staff and do not necessarily represent the views of the IMF's 
                               Executive Board. 
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                          © 2015 International Monetary Fund 
                            MONETARY POLICY AND FINANCIAL STABILITY 
       August 28, 2015      EXECUTIVE SUMMARY 
                            The issue of using monetary policy for financial stability purposes is hotly contested. 
                            The crisis was a reminder that price stability is not sufficient for financial stability, 
                            financial crises are costly, and policy should aim to decrease the likelihood of crises, not 
                            only rely on dealing with their repercussions once they occur.  
                            It is clear that well-targeted prudential policies (including micro and macroprudential 
                            regulation and supervision) should be pursued actively to attenuate the buildup of 
                            financial risks.  
                            The question is whether monetary policy should be altered to contain financial stability 
                            risks. Should it lend a hand by temporarily raising interest rates more than warranted by 
                            price and output stability objectives? Keeping rates persistently higher is also possible, 
                            but more costly.  
                            Based on our current knowledge, and in present circumstances, the answer is generally 
                            no. But, the door should remain open as our knowledge of the relationship between 
                            monetary policy and financial risks evolves and circumstances change. 
                            In principle, monetary policy should deviate from its traditional response only if costs 
                            are smaller than benefits (the principle of doing no harm on net). Costs arise in the 
                            short term, from lower output and inflation. Benefits materialize mainly in the medium 
                            term, as financial risks are mitigated, though effects are more uncertain. Based on 
                            current knowledge, the case for leaning against the wind is limited, as in most 
                            circumstances costs outweigh benefits.   
                            However, our current understanding of the channels through which monetary policy 
                            affects financial stability domestically, across borders, and over the business cycle is 
                            rapidly evolving. More circumstances may be uncovered in which deviations from a 
                            traditional policy response are warranted. Future research in this area is a key priority. 
                            In the interim, central banks should monitor and openly discuss financial stability risks, 
                            and carefully consider the costs and benefits of potential action.  
                 MONETARY POLICY AND FINANCIAL STABILITY 
                 Approved By                Prepared by Karl Habermeier and Tommaso Mancini-Griffoli (MCM), 
                 José Viñals,               Giovanni Dell’Ariccia (RES), and Vikram Haksar (SPR), under the 
                 Olivier Blanchard, and     guidance of Dong He (MCM) and Tamim Bayoumi (SPR), along with a 
                 Siddharth Tiwari           team comprising Machiko Narita, and Martin Saldias (MCM), 
                                            Pau Rabanal and Damiano Sandri (RES), and Edouard Vidon, Ran Bi, 
                                            Sally Chen, Shuntaro Hara, Stefan Laseen, Katsiaryna Svirydzenka, 
                                            Ruud Vermeulen, and Aleksandra Zdzienicka (SPR), with research 
                                            assistance provided by Zohair Alam (MCM), Federico Diaz Kalan (SPR), 
                                            and Paola Ganum (RES), input from Nasha Ananchotikul, and 
                                            Dulani Seneviratne (APD), Jiaqian Chen, Francesco Columba, and 
                                            Thierry Tressel (EUR), Nicolas Blancher, Srobona Mitra, and 
                                            Laura Valderrama (MCM), Benjamin Hunt, and Mika Kortelainen (RES), 
                                            Filiz Unsal, Marzie Taheri Sanjani, and Sophia Zhang (SPR), and 
                                            Andrea Pescatori and Jarkko Turunen (WHD). Discussions with 
                                            Stephen Cecchetti, Jeremy Stein, and Lars Svensson are gratefully 
                                            acknowledged. Assistance was provided by Sonia Echeverri and 
                                            Adriana Rota (both MCM). 
                  
                    CONTENTS 
                 Glossary __________________________________________________________________________________________ 4 
                 INTRODUCTION AND MOTIVATION ___________________________________________________________ 5 
                 THE POLICY CONTEXT AND DEFINITIONS ____________________________________________________ 10 
                 STEP 1: TRANSMISSION _______________________________________________________________________ 13 
                 A. Interest Rates and Financial Variables _________________________________________________________ 13 
                 B. Financial Variables and Macroeconomic Conditions __________________________________________ 17 
                 STEP 2: TRADEOFFS ____________________________________________________________________________ 19 
                 STEP 3: WELFARE IMPLICATIONS _____________________________________________________________ 21 
                 FURTHER CONSIDERATIONS __________________________________________________________________ 25 
                 IMPLEMENTATION ISSUES ____________________________________________________________________ 28 
                 CONCLUDING THOUGHTS _____________________________________________________________________ 29 
                 References _______________________________________________________________________________________ 52 
                  
                 2    INTERNATIONAL MONETARY FUND 
                                       MONETARY POLICY AND FINANCIAL STABILITY 
         BOXES 
         1. Cycles in Financial Variables: Concepts and Measurement ____________________________________ 31 
         2. How Severe are the Tradeoffs Between Economic and Financial Stabilization? ________________ 32 
         3. The Effect of Monetary Policy on Default Rates _______________________________________________ 33 
         4. Effects of Prolonged Monetary Policy Accommodation on Financial Stability _________________ 35 
         5. Non-Linear Interaction Between Monetary Policy on Financial Stress _________________________ 37 
         6. Predicting Crises ______________________________________________________________________________ 39 
         7. Leaning Against the Wind in a Extended Inflation Targeting Framework ______________________ 41 
         8. Cross-Border Spillovers from Monetary Policy on Financial Stability __________________________ 42 
          
         FIGURES 
         1. Output Gaps, Core Inflation, and Financial Indicators Before the Crisis _________________________ 6 
         2. Growing Financial Vulnerabilities and Costs of the Crisis _______________________________________ 7 
         3. Dealing With Financial Stability Over the Cyclical Dimension: A Decision Tree ________________ 11 
         4. From Interest Rates to Macroeconomic Conditions ___________________________________________ 13 
         5. Credit Growth and the Probability of Banking Crises __________________________________________ 19 
         6. Economic Dynamics in AEs with Banking Crises in 2007–08 ___________________________________ 20 
         7. Welfare Gains from Leaning Against the Wind Versus Using __________________________________ 22 
         8. to Lean or not to Lean, Such are the Tradeoffs ________________________________________________ 23 
          
         TABLE 
         1. Illustrative Scenarios __________________________________________________________________________ 25 
          
         APPENDIX 
         I. Past Policy Advice______________________________________________________________________________ 44 
          
                          
                                          INTERNATIONAL MONETARY FUND  3