Discussion Monetary Policy and Financial Stability: Is there a conflict? Ami Barnea, Yoram Landskroner and Meir Sokoler Paul Wachtel New York University 16 th Dubrovnik Economic Conference June 25, 2010

Disclaimer Share an interest in the issues here with the authors Share an interest in the issues here with the authors Meir and I have discussed them for yearsMeir and I have discussed them for years Yoram and I wrote a paper on the issue over 20 years ago.Yoram and I wrote a paper on the issue over 20 years ago. And, more recently, have been writing (with Tom Cooley and others) about the post crisis role of central banks. And, more recently, have been writing (with Tom Cooley and others) about the post crisis role of central banks.

Background In 70s and 80s, monetary policy in the US dominated by macro goals In 70s and 80s, monetary policy in the US dominated by macro goals We thought that the Fed also listened to other things We thought that the Fed also listened to other things Continental Illinois, Chrysler, S&L crisis – financial stability events – affected policyContinental Illinois, Chrysler, S&L crisis – financial stability events – affected policy Hard to show – this was before Taylor discovered his ruleHard to show – this was before Taylor discovered his rule Nowadays, persistent deviations from Taylors rule tell us that the Fed might be thinking of something else.Nowadays, persistent deviations from Taylors rule tell us that the Fed might be thinking of something else. So, years later, it is wonderful to see Yoram et al trying to provide a theoretical context for our youthful intuition. So, years later, it is wonderful to see Yoram et al trying to provide a theoretical context for our youthful intuition.

Taylor’s rule and the Fed funds rate

Overview of model OLG model of individuals, with banks financing risky investment under central bank oversight and with access to collateralized central bank loans. OLG model of individuals, with banks financing risky investment under central bank oversight and with access to collateralized central bank loans. Central bank objectives Central bank objectives Interest rate policy used to minimize deviation of inflation from targetInterest rate policy used to minimize deviation of inflation from target Maintain financial stability – avoid bank runs – keep financial institutions solvent subject to some constraints (can’t just bail everything out).Maintain financial stability – avoid bank runs – keep financial institutions solvent subject to some constraints (can’t just bail everything out). Set of equilibrium conditions Set of equilibrium conditions

Uses of model Shock model and look at adjustments that occur to maintain equilibrium conditions. Shock model and look at adjustments that occur to maintain equilibrium conditions. Both the real shock (productivity or inflation) and the financial shock (risk) lead to broad adjustments that show that macro policy and stability policy are connected. Both the real shock (productivity or inflation) and the financial shock (risk) lead to broad adjustments that show that macro policy and stability policy are connected. Let’s see what happens… Let’s see what happens…

Real shock Marginal product of capital goes up and inflation goes down Marginal product of capital goes up and inflation goes down More demand for capital and more risk, so banks raise nominal interest rate charged on loans. More demand for capital and more risk, so banks raise nominal interest rate charged on loans. Deposit rate increases Deposit rate increases Central bank lending rate reduced in order to meet inflation objective. Central bank lending rate reduced in order to meet inflation objective. In short -- In short -- Bank lending rate driven by risk while CB lending rate driven by inflation.

How is macro policy affecting stability? Assumption about increasing marginal risk of investment important. Assumption about increasing marginal risk of investment important. More capital investment increases probability that bank will be insolvent. More capital investment increases probability that bank will be insolvent. Banks might be more profitable but they need to increase loan loss reserves. Banks might be more profitable but they need to increase loan loss reserves. So an easier monetary policy increases risk of bank failure. So an easier monetary policy increases risk of bank failure. There is a link of monetary policy to stability – but I would not call this systemic. There is a link of monetary policy to stability – but I would not call this systemic.

Shock to risk Increase in credit risk (probability of investment failure) leads CB to increase bank capital requirement. Increase in credit risk (probability of investment failure) leads CB to increase bank capital requirement. Effects probability of bank failure – offsetting effects on bank profits from less lending but less risk of insolvency. Effects probability of bank failure – offsetting effects on bank profits from less lending but less risk of insolvency. Equilibrium lending and deposit rates might change which can affect inflation and lead to macro policy changes. Equilibrium lending and deposit rates might change which can affect inflation and lead to macro policy changes. So, stability affects macro monetary policy So, stability affects macro monetary policy

Results Complex equilibrium analysis is supportive of theme – policy interactions Complex equilibrium analysis is supportive of theme – policy interactions Don’t seem to have indentified systemic risk with the model Don’t seem to have indentified systemic risk with the model Capital markets and macro relations are not specified – but the model is complex enough as it is. Capital markets and macro relations are not specified – but the model is complex enough as it is. Need to do more to evaluate the leverage constraint. But, for this some calibration of model may be necessary to provide clear results. Need to do more to evaluate the leverage constraint. But, for this some calibration of model may be necessary to provide clear results.

Where does this lead us? Untangling complex equilibrium conditions is #1 not my forte and #2 not something we have time to do. Untangling complex equilibrium conditions is #1 not my forte and #2 not something we have time to do. My interest is to ask more broadly why is this all necessary? My interest is to ask more broadly why is this all necessary? We need this kind of modeling to help us think about the role of central banks. We need this kind of modeling to help us think about the role of central banks.

The role of central banks (1) Earliest years -- primary function of central banks was to act as fiscal agents for the government. Earliest years -- primary function of central banks was to act as fiscal agents for the government. 19th century -- Walter Bagehot articulated the importance of the lender of last resort function. 19th century -- Walter Bagehot articulated the importance of the lender of last resort function. Mid 20 th century -- macro stabilization role dominant – setting of interest rates and/or money growth. Mid 20 th century -- macro stabilization role dominant – setting of interest rates and/or money growth.

The role of central banks (2) Other modern roles -- supervision and regulation of banks (lender of last resort should know its potential customers); responsibility for the integrity of the payments and settlement systems. Other modern roles -- supervision and regulation of banks (lender of last resort should know its potential customers); responsibility for the integrity of the payments and settlement systems. Early 21 st century – Lender of last resort function expanded from liquidity support to solvency support in systemic crisis. Early 21 st century – Lender of last resort function expanded from liquidity support to solvency support in systemic crisis. Come full circle – central banks supporting the economic are playing a fiscal role. Come full circle – central banks supporting the economic are playing a fiscal role. Come full circle.Come full circle.

Central banking 1. Monetary policy 2. Supervision and regulation of individual financial institutions 3. Systemic regulation of the financial sector as a whole

1. Monetary policy Few question the importance of macro policy conducted by an independent central bank with a clear price stability mandate. Few question the importance of macro policy conducted by an independent central bank with a clear price stability mandate. But, should it be the only concern of the central bank? But, should it be the only concern of the central bank? Did this view contribute to crisis? Did this view contribute to crisis?

2. Supervision and regulation Central bank acts as the lender of last resort to provide liquidity. Central bank acts as the lender of last resort to provide liquidity. Since lenders need information about their borrowers to be able to make sound loans, central bank has a regulatory and supervisory function. Since lenders need information about their borrowers to be able to make sound loans, central bank has a regulatory and supervisory function. And, lending policy effects credits and interest rates and credit availabiity. So, monetary policy emerged from the more more traditional functions. And, lending policy effects credits and interest rates and credit availabiity. So, monetary policy emerged from the more more traditional functions. So, lending function unites #1 and #2. So, lending function unites #1 and #2.

3. Systemic regulation Systemic responsibility not a new idea – Lender of last resort function used in extremis to maintain functioning of financial system. Systemic responsibility not a new idea – Lender of last resort function used in extremis to maintain functioning of financial system. Fed lending at Y2K, 9/11Fed lending at Y2K, 9/11 If lending is to insolvent institutions, it crosses the line into a fiscal function If lending is to insolvent institutions, it crosses the line into a fiscal function Fed has extensive emergency lending powers – Section 13(3) Fed has extensive emergency lending powers – Section 13(3)

FRA section 13(3)

There is something new… Systemic risk regulation Explicit oversight of the large, complex, interconnected institutions where any insolvency would create systemic problems. Explicit oversight of the large, complex, interconnected institutions where any insolvency would create systemic problems. Ability to respond to systemic market shut downs such as the 2008 run on money market funds Ability to respond to systemic market shut downs such as the 2008 run on money market funds Economic conditions can give rise to systemically risky activity. E.g. low interest rates in the early 2000’s that promoted rapid credit expansion and some of the excesses that generated the crisis. Economic conditions can give rise to systemically risky activity. E.g. low interest rates in the early 2000’s that promoted rapid credit expansion and some of the excesses that generated the crisis.

Conclusion The recent crisis illustrates convincingly the premise of the paper – The recent crisis illustrates convincingly the premise of the paper – The three functions of central banks are clearly linked. The three functions of central banks are clearly linked. So, an independent and powerful central bank is the linchpin of good economic policy So, an independent and powerful central bank is the linchpin of good economic policy How independent and how powerful?How independent and how powerful?