Monetary Policy, Price Stability, and Financial Stability

Abstract

This chapter explores interactions of monetary policy, price stability, and financial stability for a developing country. A new, parsimonious index of financial instability is introduced and the dates of financial stress in Pakistan are documented. The dynamic interactions are investigated via impulse responses (IRs) using the local projections. Building on an augmented Taylor rule, the authors segregate the IRs across business cycle. The authors find that the monetary policy (MP) shocks generate asymmetric responses: more effective during recessions than expansions. The impulses in MP dampen inflation and output during recessions while the financial stress increases, calling for a cautious policy approach to avoid trade-offs between twin objectives of price and financial stability. The MP tightens and the output falls in the event of a financial instability shock with no significant impact on inflation. The trade-off between two objectives during downturns is also manifest here. Finally, MP responds forcefully to inflationary shocks during expansions, but at the cost of worsening financial conditions.