Monetary Policy and Financial Stability: The Role of Inflation Targeting

Abstract

This article examines the relationship between Inflation targeting (IT) and financial instability from 1990 to 2015 for Asian economies. To measure financial instability, a multidimensional financial conditioning index is calculated following the ECB's approach. Using a fixed effects panel data model the study finds that adoption of IT policy in Asian economies has an adverse impact on financial stability, thus rejecting the ‘conventional wisdom’ hypothesis. Further, the Vector Autoregression (VAR) result shows that an IT regime increases housing returns and encourages investors to take higher risks.

The relationship between price and financial stability in new monetary policy designs: the case of the US using the TVP-SVAR model

“…To achieve this purpose, the time-varying nature of the relationship between the price stability, financial stability, policy interest rate and money supply in the US, where monetary policies are designed to achieve price stability, full employment and moderate long-term interest rate targets, is studied econometrically with the TVP-SVAR model for the period 1993:12-2020:12. The results of the estimated TVP-SVAR models are parallel with the empirical findings of studies by Dhal et al (2011), Blot et al (2015), Sethi & Acharya (2020) and Sahoo (2020), who found mutual relationships between price and financial stability and who corroborate the proposition of the new environment hypothesis in the theoretical literature that price stability may not necessarily guarantee financial stability.…”

“…They found that financial stability supports price stability; however, price stability impedes financial stability. Empirical results that support the validity of the new environment hypothesis on the relationship between price and financial stability were found in studies by Blot et al (2015) and Sethi & Acharya (2020). Blot et al (2015) examined the relationship between price stability represented by the actual inflation rate and financial stability calculated in the form of an index that encompasses various indicators related to the stability of the banking and finance sector of the US and countries in the Eurozone for the period 1993: M12-2012: M12 and 1999: M1-2012: M12.…”

“…Similar to findings by Dhal et al (2011), they found that financial stability supports price stability and that price stability impedes financial stability. Sethi & Acharya (2020) investigated the relationship between price stability, captured as the actual inflation rate, and financial stability, represented by variables such as house prices and returns, with quarterly data from the period 1997: Q1-2016: Q3 on the Philippines, South Korea, Israel, Indonesia and Thailand. The empirical result of their analysis with a linear VAR model shows that in these five countries, where monetary policy designs are based on an inflation targeting regime, there is a negative relationship between price and financial stability, with price stability hindering financial stability.…”

“…The TVP-SVAR model equation defined to determine the time-varying effects of the relationships between PS, FS, FF and MS in the US is estimated for the period 1993:12-2020:12. In determining the endogenous variables in the TVP-SVAR model and their subsequent rankings in matrix A, references were drawn from studies by Granville & Mallick (2009), Blot et al, (2015) and Sethi & Acharya (2020) in the relevant empirical literature on the subject matter. (Winrats 10.0, Gauss 16.0 and OxMetrics 7.0 econometrics software packages were used in the analysis of the study data).…”

“…In these post-GFC conditions, central banks of both developed and developing countries should redesign their monetary policies to include instruments that can limit the effects of financial risks on output and inflation deficits and achieve financial stability without sacrificing price stability (Özatay, 2012;Roldán-Peña et al, 2017). In these new monetary policy designs, central banks should seek to limit the effects of financial risks on output and inflation deficits with micro/ macro prudent measures and also ensure that price stability supports financial stability (Karanovic & Karanovic, 2015;Sethi & Acharya, 2020). The theoretical foundations of these emerging new monetary policy designs after the GFC are based on the "new environment hypothesis" proposed in a study by Borio & Lowe (2002) just before the GFC.…”