Does Easing Monetary Policy Increase Financial Instability?

This paper develops a model featuring both a macroeconomic and a financial friction thatspeaks to the interaction between monetary and macro-prudential policies. There are two mainresults. First, real interest rate rigidities in a monopolistic banking system have an asymmetricimpact on financial stability: they increase the probability of a financial crisis (relative to thecase of flexible interest rate) in response to contractionary shocks to the economy, while theyact as automatic macro-prudential stabilizers in response to expansionary shocks. Second, whenthe interest rate is the only available policy instrument, a monetary authority subject to the sameconstraints as private agents cannot always achieve a (constrained) efficient allocation and facesa 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 upto the Global Recession was not excessively lax monetary policy after 2002, but rather theabsence of an effective regulatory framework aimed at preserving financial stability.