Monetary Policy, Private Debt, and Financial Stability Risks

Gregory Bauer and Eleonora Granziera

International Journal of Central Banking, 2017, vol. 13, issue 3, 337-373

Abstract: Can monetary policy be used to promote financial stability? We answer this question by estimating the impact of a monetary policy shock on private-sector leverage and the likelihood of a financial crisis. Impulse responses obtained from a panel VAR model of eighteen advanced countries suggest that the debt-to-GDP ratio rises in the short run following an unexpected tightening in monetary policy. As a consequence, the likelihood of a financial crisis increases, as estimated from a panel logit regression. However, in the long run, output recovers and higher borrowing costs discourage new lending, leading to a deleveraging of the private sector. A lower debt-to-GDP ratio in turn reduces the likelihood of a financial crisis. These results suggest that monetary policy can achieve a less risky financial system in the long run but could fuel financial instability in the short run. We also find that the ultimate effects of a monetary policy tightening on the probability of a financial crisis depend on the leverage of the private sector: the higher the initial value of the debt-to-GDP ratio, the more beneficial the monetary policy intervention in the long run, but the more destabilizing in the short run.

Date: 2017
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Working Paper: Monetary Policy, Private Debt and Financial Stability Risks (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:ijc:ijcjou:y:2017:q:3:a:9

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