FINANCIAL STABILITY: A COMPLEX ADAPTIVE SYSTEMS APPROACH
With the emergence of bubbles in the financial and real estate markets in the last decades, an
intensive discussion has started about what should be the role of the central banks towards
establishing and maintaining financial stability in the economy, the primary role of which is
generally regarded as price stability. Since the recent global financial crisis, it has been seen
that price stability cannot assure financial and macroeconomic stability, and a consensus
has emerged about that the central banks should target financial stability besides price
stability. Since, traditional interest rate policy will be insufficient to pursue these two targets
simultaneously; central banks are forced to develop new policy instruments.
In this period, financial stability has become to mean controlling exchange rates and
consumer credits for Turkey, and Central Bank of Turkey has begun to use new policy
instruments such as reserve requirements and interest rate corridor, besides the traditional
policy interest rate. Central banks use policy interest rate to control household consumption
and saving behavior via its effect on the interest rates for deposits and credits. Policy interest
rate is also effective on the investment behavior of foreign investors via its effect on the
secondary markets for government bills and bonds. Different from the short term policy rate,
reserve requirement does not affect capital flows directly, and it provides the power of control
over the credit and deposit relationship between the banks and households. Since consumer
credits have a potential for deteriorating the price stability and financial stability via its effect
on balance of payments, central banks aim to control the supply of consumer credits. In an
environment of global liquidity abundance, in order to impede short term capital inflow,
central bank may lower the policy interest rate and it may increase reserve requirements as an
alternative policy instrument in order to control consumer credits.
Another policy instrument used in the Turkey example is the interest rate corridor which
is simply the difference between the central bank’s overnight lending and borrowing rates.
Interest rate corridor is used to manipulate banks’ preference between liquidity and foreign
exchange.
System dynamics is a methodology used to model complex adaptive systems which are based
on control theory and nonlinear differential equation systems. Since economy and particularly
the financial system are complex adaptive systems which consist of elements and complex
relations among them, system dynamics methodology provides vast opportunities for formal
and nonlinear modeling of them. Then, these formal modals can be used to make computer
simulations and to design more efficient policies and organization structures.
In this study, the example of Turkey will be used to illustrate the central bank’s effectiveness
of policy instruments on targeting price stability and financial stability simultaneously in a
developing country. Treated as a complex adaptive system, the economy and the financial
system will be modeled with system dynamics methodology. Then the effect of global
liquidity conditions on the effectiveness of the central bank’s policy instruments will be
investigated based on the scenarios.