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Financial stability, deflation, and monetary policy

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  • Marvin Goodfriend

Abstract

The paper explores the relationship between financial stability, deflation, and monetary policy. A discussion of narrow liquidity, broad liquidity, market liquidity, and financial distress provides the foundation for the analysis. There are two preliminary conclusions. Equity prices are a misleading guide for interest rate policy. Monetary policy tactics protect market liquidity while maximizing the central bank's leverage over longer-term interest rates and aggregate demand. ; Monetary policy is a fundamental source of deflation and stagnation risk when price stability is fully credible. A central bank can be fooled by its own credibility for low inflation into being insufficiently preemptive in a business expansion. Then monetary policy can be constrained by the zero bound from reducing real interest rates enough in the subsequent contraction. The chain of events that leads to deflation and stagnation can be weakened or broken in a number of places. Monetary policy has the power to preempt deflation and the power to overcome the zero bound to restore prosperity after a deflationary shock. Fiscal policy is likely to be relatively ineffective at best and counterproductive at worst.

Suggested Citation

  • Marvin Goodfriend, 2001. "Financial stability, deflation, and monetary policy," Working Paper 01-01, Federal Reserve Bank of Richmond.
    • Handle: RePEc:fip:fedrwp:01-01
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    Cited by:

    1. Aaron MEHROTRA, 2004. "Could Japan Target the Price Level or Inflation - What Happens to Monetary Policy Effectiveness during Disinflation?," Economics Working Papers ECO2004/02, European University Institute.
    2. Kato, Ryo & Nishiyama, Shin-Ichi, 2005. "Optimal monetary policy when interest rates are bounded at zero," Journal of Economic Dynamics and Control, Elsevier, vol. 29(1-2), pages 97-133, January.
    3. Takatoshi Ito & Frederic S. Mishkin, 2006. "Two Decades of Japanese Monetary Policy and the Deflation Problem," NBER Chapters, in: Monetary Policy with Very Low Inflation in the Pacific Rim, pages 131-1997, National Bureau of Economic Research, Inc.
    4. Fabien Clive Ntonga Efoua, 2019. "De l'Euphorie à la Panique : Une Relecture de l'Instabilité Financière des Années 1980 dans la Zone BEAC," Post-Print hal-03198360, HAL.
    5. Thorsten V. Koeppl, 2009. "How Flexible Can Inflation Targeting Be? Suggestions for the Future of Canada's Targeting Regime," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 293, August.
    6. Christian Bordes & Laurent Clerc, 2007. "Price Stability And The Ecb'S Monetary Policy Strategy," Journal of Economic Surveys, Wiley Blackwell, vol. 21(2), pages 268-326, April.
    7. Benner, Joachim & Borbély, Dóra & Gern, Klaus-Jürgen & Kamps, Christophe & Kamps, Annette & Sander, Birgit & Scheide, Joachim, 2003. "Durchgreifende Erholung der Weltkonjunktur nochmals verzögert," Open Access Publications from Kiel Institute for the World Economy 2983, Kiel Institute for the World Economy (IfW Kiel).
    8. Helmut Wagner, 2005. "Globalization and financial instability: Challenges for exchange rate and monetary policy," International Journal of Social Economics, Emerald Group Publishing, vol. 32(7), pages 616-638, July.
    9. Ortiz, Marco, 2014. "Fat-Tailed Shocks and the Central Bank Reaction," Working Papers 2014-002, Banco Central de Reserva del Perú.
    10. Andolfatto, David, 2003. "Monetary Implications of the Hayashi-Prescott Hypothesis for Japan," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 21(4), pages 1-20, December.
    11. MILEA, Camelia, 2013. "Risks And Constraints For The Monetary Stability," Studii Financiare (Financial Studies), Centre of Financial and Monetary Research "Victor Slavescu", vol. 17(3), pages 52-62.
    12. Paweł Marszałek, 2006. "Trudności koordynacji polityki pieniężnej i polityki fiskalnej we współczesnej gospodarce," Gospodarka Narodowa. The Polish Journal of Economics, Warsaw School of Economics, issue 9, pages 57-75.
    13. Bergman, U. Michael & Hansen, Jan, 2002. "Financial Instability and Monetary Policy: The Swedish Evidence," Working Paper Series 137, Sveriges Riksbank (Central Bank of Sweden).
    14. Nagayasu, Jun, 2004. "The Term Structure of Interest Rates and Monetary Policy during a Zero Interest Rate Period," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 22(2), pages 19-43, May.
    15. Olivier de Bandt & Christian Pfister, 2003. "Politique monétaire, capital bancaire et liquidité des marchés," Revue d'Économie Financière, Programme National Persée, vol. 73(4), pages 213-226.
    16. William R. White, 2004. "Are changes in financial structure extending safety nets?," BIS Working Papers 145, Bank for International Settlements.
    17. Michal Jurek & Pawel Marszalek, 2015. "Policy alternatives for the relationship between ECB monetary and financial policies and new member states," Working papers wpaper112, Financialisation, Economy, Society & Sustainable Development (FESSUD) Project.
    18. M. Zouaoui & G. Nouyrigat & F. Beer, 2010. "How does investor sentiment affect stock market crises? Evidence from panel data," Post-Print halshs-00534754, HAL.

    More about this item

    Keywords

    Deflation (Finance); Liquidity (Economics); Monetary policy; Financial crises; Interest rates; Prices;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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