Price Stability and Financial Stability: Designing the Central Bank Mandate

Emmanuel Caiazzo () and Alberto Zazzaro ()
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Emmanuel Caiazzo: Department of Economics and Statistics, University of Naples Federico II, CSEF, and MoFiR

No 191, Mo.Fi.R. Working Papers from Money and Finance Research group (Mo.Fi.R.) - Univ. Politecnica Marche - Dept. Economic and Social Sciences

Abstract: In this paper, we model a novel trade-off between price stability and financial stability in central banking. This trade-off arises from the interaction between the monetary policy interest rate, the central bank rescue interventions, and the degree of bank illiquidity. We characterize and compare the equilibrium outcomes, in terms of monetary policy, rescue policy, and bank investment decisions, that arise under a strict inflation-targeting mandate with those that instead emerge under a dual mandate, in which the central bank is required to account for both the costs of inflation and the costs associated with financial instability. Our analysis suggests that an inflation-targeting mandate may be advisable when the economy is subject to frequent and severe inflationary shocks that would require substantial policy rate adjustments, or when liquidity risks in the banking system are neither too high nor too low. Otherwise, a mandate that explicitly requires the central bank to take financial stability into account, even at the cost of relaxing strict inflation control, may be preferable.

Keywords: Central Banking; Financial stability; Rescue Policies (search for similar items in EconPapers)
JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Pages: 58
Date: 2025-07
New Economics Papers: this item is included in nep-cba, nep-fdg, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:anc:wmofir:191

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