Taking Away the Punch Bowl: Monetary Policy and Financial Instability

Abstract: In the last decade, the problem of financial instability has surged to the forefront of economists’ and policymakers’ attention. This paper presents a theory of financial crises due to excessively loose monetary policy. Financial crises are inefficient, but occur even though the central bank acts to maximize the sum of households’ utilities. Monetary policy sets low interest rates, which most of the time delivers rapid asset-price inflation and a build-up of debt, but also occasional financial crises where asset prices collapse and deleveraging occurs. This inefficient financial instability occurs even though the central bank maximizes social welfare because too many agents would lose if the central bank were to `take away the punch bowl’. To avoid financial crises, the policy implication is that central bank need to become ‘conservative’ in a different sense: monetary policy should be set in the interests of savers rather than borrowers.