Link between monetary policy and financail stability
February 13, 2012
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Adrian and Shin has explored the dynamics of the shadow banking system through several articles (see the web site of New York Fed for references). Today’s quote is from an early article from 2009 “Money, Liquidity and Monetary Policy” where they conclude that …
there is a case for rehabilitating a role for balance sheet quantities for the conduct of monetary policy.
The note that their results also highlight the way that monetary policy and policies toward financial stability are linked:
When the financial system as a whole holds long-term, illiquid assets financed by short-term liabilities, any tensions resulting from a sharp pullback in leverage will show up somewhere in the system. Even if some institutions can adjust their balance sheets downward with flexibility, there will be some that cannot. These pinch points will be those institutions that are highly leveraged and that hold long-term illiquid assets financed with short-term debt. When the short-term funding dries up, they will face a liquidity crisis.
Therefore, balance sheet dynamics imply a role for monetary policy in ensuring financial stability.
The waxing and waning of balance sheets have a monetary policy dimension in terms of regulating aggregate demand, but also the crucial dimension of ensuring the stability of the financial system. Contrary to the common view that monetary policy and policies toward financial stability should be seen separately, they are inseparable. At the very least, there is a strong case for better coordination of monetary policy and policies toward financial stability.
Their papers have been around for some time, but perhaps this position have not yet made an impact on how central banks organize their work?