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Document Type

Articles

Abstract

This paper proposes two insights into financial regulation and monetary policy. The first enhances understanding the relationship between them, building on the automobile metaphor that describes monetary policy: when to accelerate or brake for curves miles ahead. Enhancing the metaphor, financial markets are the transmission. In a financial crisis, markets cease to function, equivalent to a transmission shifting into neutral. This explains both monetary policy’s diminished effectiveness in stimulating the economy and why the financial crisis shock to real economic output greatly exceeded central bank forecasts.

The second insight is that both excess leverage and fundamental mispricing of asset values are necessary to produce a crisis. Central banks ought to focus on excess leverage rather than on asset valuation to prevent a crisis. Markets are better at asset valuation and the central bank’s macro- and microprudential toolkits are better suited to deal with leverage.

Incorporating these insights informs central banking and financial regulation in theory and practice. Integrating monetary policy and financial regulation over the course of business and financial cycles enhances policy outcomes. The theory allows central bankers to better understand when financial stress metastasizes into a panic.

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