Does Easing Monetary Policy Increase Financial Instability?

This paper develops a model featuring both a macroeconomic and a financial friction that speaks to the interaction between monetary and macro-prudential policy and to the role of U.S. monetary and regulatory policy in the run up to the Great Recession. There are two main results. First, real interest rate rigidities in a monopolistic banking system increase the probability of a financial crisis (relative to the case of flexible interest rate) in response to contractionary shocks to the economy, while they act as automatic macro-prudential stabilizers in response to expansionary shocks. Second, when the interest rate is the only available policy instrument, a monetary authority subject to the same constraints as private agents cannot always achieve a (constrained) efficient allocation and faces a trade-off between macroeconomic and financial stability in response to contractionary shocks. An implication of our analysis is that the weak link in the U.S. policy framework in the run up to the Global Recession was not excessively lax monetary policy after 2002, but rather the absence of an effective second policy instrument aimed at preserving financial stability.