Financial instability and monetary policy

Central banks, in executing monetary policy, while pursuing traditional objectives such as targeting and controlling the rate of inflation, may try also to promote financial stability. This discussion is in line with the recent debate as to whether price stability is sufficient to foster financial stability, or whether a trade-off exists (at least in the medium-run), and if the latter is the case, whether asset prices should be explicitly targeted. In this paper, we explore a core monetary policy game played between the central bank and the financial sector. The loss function of the central bank incorporates its commitments to control financial asset prices. We examine monetary policy both under commitment to an instrument rule and under discretion. Our analysis concludes that when a central bank addresses financial stability as a main and systematic component of its decision making process, namely as an explicit monetary policy objective, then policy yields better results in terms of controlling inflation, anchoring inflation expectations and imposing more prudence to the operation of the financial sector, when conducted under commitment to a rule. Therefore, we contend that the contribution of the paper is twofold: namely, in terms of the game-theoretic method used to analyse monetary policy under financial (in)stability; and, in terms of the results proposed (rules are superior to discretion even when control of financial instability is an explicit component of the central bank’s loss function). We conclude by relating our results to the recent financial crisis and the concomitant policy reaction functions of central banks such as the ECB.