Financial Regulation and Stability
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Financial Regulation and Stability

Lessons from the Global Financial Crisis

Charles Goodhart and Dimitrios P. Tsomocos

This book addresses the interaction of monetary and regulatory policy to achieve the important goal of price and financial stability. The authors show how financial stability can be assessed and measured continuously, and discuss the interrelationships between liquidity and default. Without default there would be no concern about liquidity. But the financial crisis was not just a liquidity problem, and requires a general equilibrium model. Their general equilibrium analysis demonstrates how policy should depend on understanding all the relevant factors.
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Chapter 9: Debt deflation effects of monetary policy

Li Lin, Dimitrios P. Tsomocos and Alexandros P. Vardoulakis

Abstract

We assess the role that monetary policy plays in the decision to default using a General Equilibrium model with collateralized loans, trade in fiat money and production. The monetary authority extends long-term credit against risky collateral along with its traditional monetary operations. The value of collateral depends on traditional monetary policy and agents can optimally choose to default depending on the relative value of the collateral to the face value of the loan. Default results in foreclosure, higher borrowing costs, inefficient investment and a decrease in total output. We show that pre-crisis contractionary monetary policy interacts with Fisherian debt-deflation dynamics and can increase the probability that a crisis occurs.

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