Chapter 4: Financial Stability and Monetary Policy: A Framework
Gerhard Illing1 INTRODUCTION Monetary policy has been a great success over the past 15 years: worldwide, inﬂation has been reduced steadily, and output volatility seems to be well under control. The performance of central banks in ﬁghting inﬂation has been stunningly impressive. Whereas for a long time they were accused of suﬀering from dynamic inconsistency (the temptation to give in to incentives to carry out surprise inﬂation), the credibility of central banks now seems to be at its highest level ever. Following the advice of modern macroeconomic theory, which provides a sound welfare theoretical framework for price stability, most modern central banks try to stabilize the price level by steering aggregate demand via changes in nominal and real interest rates, respectively. The ‘New Neoclassical Synthesis’ (Woodford, 2003) provides a well-established framework for this approach to monetary policy, pointing out the crucial role of commitment in order to eﬀectively inﬂuence long-term real interest rates by signalling the intended path of nominal rates in advance. According to prominent proponents of this framework, such as Woodford, money supply does not play a signiﬁcant role. Just at a time when central banking practices seem to be converging with theory, there is increasing concern among practitioners that an excessively generous provision of liquidity contributes to excessive asset-price movements (increases in equity and housing prices), endangering ﬁnancial stability. The fear that loose monetary policy contributes to a rise in asset prices with the risk of a serious breakdown of...
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