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Working Paper, No. 2022-06, February 2022 Crossref
Financial Stability Considerations for Monetary Policy: Theoretical Mechanisms

This paper reviews the theoretical literature at the intersection of macroeconomics and finance to draw lessons on the connection between vulnerabilities in the financial system and the macroeconomy, and on how monetary policy affects that connection. This literature finds that financial vulnerabilities are inherent to financial systems and tend to be procyclical. Moreover, financial vulnerabilities amplify the effects of adverse shocks to the economy, so that even a small shock to fundamentals or a small revision of beliefs can create a self-reinforcing feedback loop that impairs credit provision, lowers asset prices, and depresses economic activity and inflation. Finally, monetary policy may affect the buildup of vulnerabilities, but the sign of the impact along some of its transmission channels is theoretically ambiguous and may vary with the state of the economy.


Working papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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