Monetary Policy, Private Debt and Financial Stability Risks

Gregory Bauer and Eleonora Granziera

Staff Working Papers from Bank of Canada

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 18 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.

Keywords: Credit and credit aggregates; Financial stability; Monetary Policy; Transmission of monetary policy (search for similar items in EconPapers)
JEL-codes: C21 C23 E E52 E58 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2016
New Economics Papers: this item is included in nep-cba, nep-fdg, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (22)

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Journal Article: Monetary Policy, Private Debt, and Financial Stability Risks (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:16-59

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