Government and the central banks

Government and the central banks

05 Aug 2011

Governments and central banks often tend to ‘pass the buck’, trying to induce the other institution to deal with the dangers of excessive booms in housing and stock markets. This may lead to unnecessary financial instability.

EconomicsThat lesson from the global financial crisis is highlighted in a new study by La Trobe University Senior Lecturer in Economics and Finance, Dr Jan Libich.

Policy-makers have long been concerned with the issue of whether fluctuations of assets — as an indicator of inflation or of financial fragility — should be taken into account when setting monetary or fiscal policies.

‘In the light of the unusual financial instability of 2007–2009, it is important to look again at the appropriateness of giving various asset price movements a role in the setting of macroeconomic policies,’ says Dr Libich.

He and international colleagues, Professor Andrew Hughes Hallett—George Mason University— and Petr Stehlik—University of West Bohemia—attempted to re-assess to what extent the central bank or the government should respond to developments that can cause financial instability, such as housing or asset bubbles, overextended budgetary policies, or excessive public and household debt.

‘Our analysis shows that the answer depends on a number of characteristics of the economy, as well as on the monetary and fiscal policy preferences with respect to inflation and output stabilization.

‘Importantly, we found that if the government and the central bank have discretion over the degree with which they respond to the driving forces of financial instability they tend to respond insufficiently. This is due to a free-riding problem whereby they try to shift the responsibility to the other policy, and such actions lead to socially inferior macroeconomic outcomes,’ he says.

The implication of such free-riding is that the structure of the delegation process of macroprudential policies, which determines the incentives of the policy makers, plays an important role in the preservation of financial stability.

‘Macroprudential objectives have to be legislated more transparently so that discretion and uncertainty over policy responses are reduced, and policy actions are more predictable by the public,’ says Dr Libich.

The study— Macroprudential Policies and Financial Stability— published in the Economic Record in June and is available on request.

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