The Conduct of Monetary Policy under Risks to Financial Stability: A Game - Theoretic Approach

Asset prices offer useful information for monetary policymakers in the short-term, yet their significant relationship to primary policy-indicators is debated. In one view bubbles are difficult to recognise and central banks should act just against the adverse consequences of their unwinding. The opposite view advocates ‘pre-emptive’ monetary policy as financial imbalances accumulate aiming to forestall such consequences. After reviewing the debate, we evaluate ‘pre-emptive’ monetary policy when financial stability is an explicit objective replacing the output-gap. Modelling a game between a central bank and the financial sector similar to Barro and Gordon (1983), we examine monetary policy under commitment and discretion. In contrast to the relevant literature, we conclude that pre-emptive monetary policy succeeds in better controlling inflation, anchoring inflation expectations and imposing more discipline to the financial sector when committed to a rule. The model is extended to incorporate incomplete information about the policy objectives. We evaluate the effect of vagueness about the central bank’s preferences for financial stability in the behaviour of the central bank and the financial sector, and how reputation-building affects the conduct of discretionary policy. Finally, we discuss the relevance of our conclusions in the light of the global financial crisis initiated in August 2007.