Remarks by Paul Beaudry
Deputy Governor of the Bank of Canada
Université Laval
January 30, 2020
Québec, Quebec
Monetary Policy and Financial
Vulnerabilities
Introduction
It gives me great pleasure to be at Laval University today to talk to you about monetary
policy. I am from the Quebec City area, and I studied in the economics department here
at Laval in the early 1980s. I know several of you well, and I am very happy to see you
again. Being here in January brings back many memories. When I was a student, the
economics department was at the Pavillon De Koninck. I had an apartment at the corner
of Chemin Ste-Foy and Du Vallon. To get to classes I had to cross a large field that has
now almost disappeared. In January, with temperatures at 20 below and the wind
blasting across the field, I felt like I was in a film in Siberia. I really had to like economics
to motivate myself to attend classes in the middle of winter! But the quality of the
education offered here pushed me to make it to every class.
Apart from the cold, when I think about my time at Laval-and at CEGEP de Ste-Foy
near here-I am struck by how different things were then in terms of inflation and
interest rates. In the late 1970s and early 1980s, inflation was very high and variable.
That created a lot of frustration. The Bank of Canada, like many other central banks,
responded by raising interest rates. In Canada, rates reached a peak of 21 percent.
These high borrowing costs eventually succeeded in reducing inflation, but at the cost of
a major recession. In fact, in terms of unemployment, it created a deeper recession in
Canada than the one associated with the 2008 financial crisis. It was a difficult time for
many people. I paused my studies between CEGEP and university to work in the
construction industry. I can tell you that it was a difficult time for this sector. But in this
environment of social difficulty and high unemployment, I became interested in
macroeconomics and monetary policy. In particular I thought there must be better ways
to manage the macroeconomy.
Fortunately, we are now in a much better situation.
As you may know, since the 1990s, the Bank of Canada has conducted monetary policy
with the aim of keeping inflation close to 2 percent. To achieve this goal, we choose the
overnight policy interest rate to help steer the economy toward the full use of its
resources-in terms of both employment and capital. We know from experience that
inflation will tend to stay close to our 2 percent target if the economy is close to its
potential. But we also recognize that there is a delay between when we move interest
rates and when we see the effect of that move on the economy. We take this delay into
account when making our policy decisions. I think it is fair to say that, using this
framework, the Bank of Canada has been extremely successful at keeping inflation
close to 2 percent.1
Still, the Bank of Canada is always looking for ways to improve our conduct to keep
inflation on target. In particular, we want to make sure that our decision-making
framework is not too narrow or too short-sighted. One issue that we've looked at a lot
over the past decade is how financial factors affect the economy-that is, how much
money Canadians are borrowing and lending, and what implications that has for
monetary policy. This is one of the questions raised by the financial crisis of 2008.
Given my role at the Bank in overseeing the Financial Stability Department, my talk
today is aimed at clarifying some current thinking around financial vulnerabilities and
monetary policy. It is important to stress that our thinking on these issues is still a work
in progress and that a proper quantification of the forces at play remains an area of
active research.
After briefly reviewing the main sources of financial vulnerabilities, I will cover the
following:
1) How financial vulnerabilities could give rise to unique challenges for monetary
policy
2) How the Bank currently incorporates financial vulnerabilities into its discussion of
monetary policy and what we plan to do to move forward
3) Why monetary policy has a role in addressing financial vulnerabilities along with
macroprudential and other policies
4) How international financial vulnerabilities affect Canada
It is clear to me that financial vulnerabilities raise new challenges for central banks for
two reasons. First, they give rise to a different type of trade-off-an intertemporal
tradeoff-which can create a conflict between the shorter term and longer term. And second,
they evolve more slowly than traditional monetary factors, and their impact is generally
harder to predict.
What are financial vulnerabilities?
Let's start with the basics. There are many different types of financial vulnerabilities, and
every year our Financial System Review presents the most important for Canada. It is
helpful to emphasize three main classes of financial vulnerabilities: balance sheet
vulnerabilities, asset price vulnerabilities and risk allocation vulnerabilities.
Balance sheet vulnerabilities arise when assets and liabilities are not well matched.
These can be on the consumer side, the corporate side or the financial intermediary
side.2 They are usually associated with debt or leverage, but they can also involve a
liquidity mismatch. For example, on the household side, when debt levels are very high
relative to income and assets, a small change affecting household finances can cause
payment difficulties and possible default since financing costs can't be easily adjusted.
This is clearly an important worry in Canada and is likely our biggest balance sheet
vulnerability.
Asset price vulnerabilities refer to situations where asset prices rise well above a value
that can be justified by fundamentals-driven by either over-optimism or herd
behaviour. Again, the easiest example of this for Canada relates to house prices. As we
have seen in some cities, house prices can sometimes take on a dynamic of their own,
leading to situations of extreme unaffordability. Obviously, balance sheet vulnerabilities
and asset price vulnerabilities can interact, creating an even bigger problem.
Risk allocation vulnerabilities are slightly harder to describe. These vulnerabilities
involve situations in which those that are holding the most risk in the economy-through
their asset holdings-may not be in a good position to manage and absorb it.3 They
may not be fully aware of the risks they are facing. This appears to have arisen in the
asset-backed commercial paper (ABCP) market in 2007, when many investors
complained about not understanding the nature of the product they had bought. Climate
risk could also give rise to a risk allocation vulnerability if people have a poor
understanding of which assets are likely to perform badly as climate-related events
become more frequent and we transition to a lower-carbon economy.
The risk of boom and bust
The causes of economic fluctuations in Canada are varied-particularly because we are
an open economy, vulnerable to the winds of global economic storms. But we as central
bankers want to ensure we are lessening the occurrence of potential boom and bust
periods, not causing them. For that reason, I'd like to focus on how the dynamics
associated with certain financial factors could cause boom-bust periods and how
monetary policy may need to adjust to avoid being a contributing factor.
It is important to understand how financial vulnerabilities differ from other forces
generally included in the discussion of monetary policy. In macroeconomic models,
external disturbances or shocks are transmitted to the economy through a set of
amplification and propagation mechanisms. The most common of these are referred to
as multipliers and accelerators. Multipliers are widely understood, especially in the case
of consumption, where a positive feedback between income and consumption can make
the impact of a shock larger.
Throughout my discussion, I will often refer to positive and negative feedback effects, so
it may be worth being explicit about these terms. Positive feedback effects relate to
forces that build on one another: for example, when income boosts consumption and
consumption boosts income. To take a sports analogy, a positive feedback would arise
when more training gives you more energy, and more energy allows you to train more.
In this analogy, we can also see how a negative feedback can arise. If you train harder,
you put pressure on your joints, and over time that can cause injuries that force you to
train less. That would be an example of a negative feedback.
An accelerator force, especially the type of financial accelerator force expressed in
Bernanke and Gertler (1989),4 reflects a positive feedback that develops over time. The
standard financial accelerator works through the balance sheets of firms. If a firm's
balance sheet is in good shape, it can more easily invest in equipment, structures and
research and development. Given that balance sheets tend to improve in expansions
due to increased profits, this gives rise to a clear positive feedback mechanism (see the
Appendix).
It follows that a reduction in interest rates in such an environment-even if it is
temporary-can be amplified and propagated over time and lead to long-lived effects on
the economy. In particular, the feedback on firms' net worth from an economic
expansion can cause a small positive shock to the economy to evolve into a prolonged
boom as firms' higher net worth increases investment. This increases activity and in turn
increases net worth and so on. Figure 1 qualitatively illustrates such an outcome, which
is generally referred to as a financial accelerator.
- 5 -
Figure 1: In the presence of a financial accelerator, an interest rate cut generates a sustained
increase in production
Deviation of GDP
from steady state
0
1 2 3 4 5 6 7 8 9 10
Period
Strong financial accelerator Weak financial accelerator
Source: Bank of Canada illustration reflecting System A in the Appendix
Monetary policy fully recognizes and confronts this type of dynamic every day as both
positive and negative shocks hit the economy. However, one aspect of this type of
feedback worth noting is that it never gives rise to a boom-bust pattern. If the initial
impulse is positive, it will never directly cause below-normal economic activity later.
Shocks in such a system cause either a virtuous cycle or a vicious cycle, but not a mix
of the two. Good outcomes build on each other, and bad outcomes do the same. That is
what a positive feedback does.
This is where vulnerabilities are different from such accelerator forces. Vulnerabilities,
such as high debt or excessive leverage, are forces that grow during expansions. But
contrary to accelerator forces, they can eventually weigh negatively on the economy by
foreshadowing potentially bad future outcomes.5 This potential negative effect of debt
accumulation could arise even though debt accumulation for households and firms has
many positive benefits. For example, if we introduce household debt in the above
5
There are different ways to define a vulnerability in a system. The main notion is a state variable that
foreshadows the possibility of bad future outcomes. However, to make the notion operational, one needs an
additional element to prevent any variable (or its negative) from becoming a vulnerability. To this end, one could
define a vulnerability as a state variable that causes a negative skew to the future distribution of economic activity
(as in Adrian, Boyarchenko and Giannone 2019). The drawback I see with this definition is that it implies that
almost any variable (or its negative) that affects the shape of the distribution of output becomes a potential
vulnerability, while it omits variables that negatively weigh on future outcomes even if they don't change the
shape of the distribution. For this reason, I define a vulnerability as having a negative weight on the future
distribution of economic activity while also contributing to the expansion. This definition ties vulnerabilities to the
notion of intertemporal trade-offs.
scenario and we allow this debt accumulation to affect consumption decisions, then the
dynamics can change quite drastically. Here I want to introduce the possibility that
household spending decisions are negatively affected by the past accumulation of
consumer debt. This addition introduces in the system what I am calling a financial
vulnerability (see the Appendix).
In this slightly richer environment, a fall in interest rates can now cause an initial boom
in economic activity as more household debt increases consumption. But this may be
followed by a later bust if the accumulation of household debt becomes a drag on
consumer spending. The bust can be quite delayed relative to the initial disturbance that
induced a boom period. This boom-bust dynamic makes vulnerabilities distinct from
accelerators and gives rise to new challenges and trade-offs for monetary policy. For
example, if a central bank in such an environment were to cut interest rates to stimulate
demand and help inflation attain its target, this would generally favour an expansion-
and increase inflation as desired. However, if there were financial vulnerabilities at play,
this could turn out to be costly later. Financial vulnerabilities, such as consumer debt,
have the potential to accumulate sufficiently during the boom and eventually reverse the
initial positive impact of lower interest rates. For instance, the drag of consumer debt on
household spending can eventually lead to a reduction in consumption below its
steadystate level because people feel poor and need to repay loans. When this happens, the
downturn induced by debt will generally be amplified as firms start making less, which in
turn leads them to cut back on investment. The resulting bust period makes attaining
the inflation target at a later date more challenging.
Figure 2: In the presence of a financial vulnerability, an interest rate cut generates a delayed bust
in production
Deviation from
steady state
0
1 2 3 4 5 6 7 8 9 10
Period
GDP Debt
Source: Bank of Canada illustration reflecting System B in the Appendix
It is important for an inflation-targeting central bank to recognize whether vulnerabilities
are present, as these can give rise to this difficult trade-off dynamic. The challenge is
that the same policy choice that helps the central bank attain its inflation target in the
short run may be making it more difficult to attain its target in the longer run.
Accordingly, the discussion of vulnerabilities for an inflation-targeting central bank
should be seen not as a change in its objective but as a recognition of this potential
intertemporal trade-off.6
So far, I have highlighted a key feature that distinguishes vulnerability forces from
accelerator forces. That distinction is the potential for a negative feedback loop in the
presence of vulnerabilities, as opposed to a positive feedback loop associated with a
pure accelerator force. However, this is not the only way to distinguish vulnerabilities
from accelerators. An important additional element is the role of triggers. When we
consider most vulnerabilities, they typically play a negative role in economic activity
when they are activated by some event. For example, the key financial vulnerabilities
behind the 2008 financial crisis were activated by the fall of Lehman Brothers. The
collapse of Lehman-itself a symptom of many other problems-played the role of
trigger (see the Appendix).
Returning to our earlier example of household expenditures that depend negatively on
the past accumulation of consumer debt, it is easy to imagine how this may be activated
by a trigger. For example, the trigger may be a repricing of risk on international markets
that causes a change in long-term mortgage rates. As long as the trigger is dormant, the
negative effect of the vulnerability is muted; but this effect comes into full force once the
trigger activates it.
The effect of a current vulnerability on future economic activity can be visualized as a
change in the distribution of future economic activity (Figure 3). A higher vulnerability
means that in the future, the expected distribution of economic activity shifts to the left.
This could be due to a shift that is dominated in the tails (Figure 3b) or that is spread
out more equally (Figure 3a). The actual way the distribution changes shape depends
on the interaction between the vulnerability and the trigger.
Given the two possibilities illustrated in Figure 3 and their potential combination, it is
useful to track how the tail of the distribution shifts when vulnerabilities accumulate.
- 8 -
Figure 3: Financial vulnerabilities change the distribution of future growth of gross domestic
product
a) Effect mainly through the mean of the
b) Effect mainly through the skewness of the
distribution
distribution
GDP at risk, 5th
th
percentile
New 5 percentile,
GDP at risk
Future Future
GDP GDP
growth growth
We will also see this at play when I discuss our growth-at-risk framework. However,
tracking the tail of the distribution does not imply that vulnerabilities act only on the tails.
Instead, tracking the tail should be seen as a robust means of measuring the effects of
vulnerabilities whether they affect the tail, the mean or both.
How do we incorporate financial vulnerabilities in our modelling efforts at the Bank of
Canada? Before I explore this, let me stress that the relevance of financial
vulnerabilities for monetary policy remains a debated issue. Some research suggests
vulnerabilities are of utmost importance, while other research concludes that in many
cases they may be of minor importance or it may be too costly to address them with
monetary policy (Svensson 2017). In fact, at the time of our 2016 inflation-target
renewal, the Bank emphasized research that concluded the benefits of using interest
rates to lean against the buildup of household debt were quite limited, while the costs in
terms of foregone output were large.7 Since then, some new research suggests that
allowing for the effects of monetary policy on housing markets could significantly affect
these calculations (Adam and Woodford 2018). More broadly, the endogenous risk
taking of borrowers or financial institutions can add another channel to the traditional
monetary policy transmission mechanism (Adrian and Liang 2018).
For an inflation-targeting central bank, the dynamics brought on by financial
vulnerabilities are particularly relevant if they create a conflict related to how interest
rates may affect the economy in the shorter run versus the longer run. We confronted
this issue in last October's interest rate decision, when there was uncertainty in the
economy and an "insurance cut" was discussed. Given the weakness in the global
economy, we could have considered a cut to ensure the Canadian economy wouldn't
perform below its potential and pull inflation below target. But given the state of the
financial vulnerabilities in Canada, we judged the risk of reigniting an acceleration in
house price expectations and a buildup of debt was too high-and that could make
attaining our inflation target harder in the long run. This is a real-life example of the
intertemporal trade-off I've spoken about: the gain in the short run did not seem to be
worth the potential cost in the long run. If financial vulnerabilities don't spark such a
conflict, then they don't create a new trade-off that central banks need to worry about.
An additional challenge in evaluating the role of vulnerabilities for monetary policy is the
time frame over which financial vulnerabilities may play out. If they play out only very
slowly, which is quite plausible, then it becomes very difficult to properly establish the
quantitative link between interest rate decisions and future effects of financial
vulnerabilities on the economy. That is, if the effects of interest rate cuts come many
years later, it is more difficult to say whether they caused the vulnerabilities.
While the role of financial vulnerabilities is debated, several different pieces of evidence
suggest they are most likely relevant. For example, let me discuss evidence based on
countries that experienced long periods of above-normal credit growth.
Figure 4: Countries that experienced a banking crisis in 2008 had a stronger growth of credit
before the crisis and a slower recovery after the crisis
a) Credit-to-GDP gap
b) Real GDP, index: 2007=100
130
15
125
10
120
115
GDP
5
of 110
105
0
Index
100
-5
95
Percentage
90
-10
85
-15 80
OECD countries without banking crisis in 2008 OECD countries without banking crisis in 2008
OECD countries with banking crisis in 2008 OECD countries with banking crisis in 2008
Note: The definition of banking crises follows Laeven and Valencia (2018). For both groups of countries, the average is
weighted using real GDP. Although simple, the Bank for International Settlements credit-to-GDP gap measure faces a number
of limitations (Grieder, Hogg and Duprey 2017).
Sources: Laeven and Valencia (2018), International Monetary Fund, Bank for International Settlements and Bank of Canada
Figure 4 contrasts the histories of countries that did or did not experience a banking
crisis in 2008. In Figure 4a, we see that countries that experienced a banking crisis in
2008 had above-average credit growth several years before. Moreover, in Figure 4b we
see that these same countries witnessed lower economic outcomes during and after
2008. This illustrates there may be a long lag between the accumulation of
vulnerabilities and subsequent poor economic outcomes. Note that I am not claiming
that the buildup of this debt was primarily driven by monetary policy. However, if interest
rate decisions can partially spark the debt buildup over many years, this would present
a new challenge for a central bank like the Bank of Canada, since the time frame
usually used to discuss the effects of monetary policy is only two years. Taking these
effects into account could thus require the Bank to extend the period of analysis of
monetary policy.
Evidence also suggests that the effects of some financial vulnerabilities may play out at
a slightly higher frequency than that associated with debt and leverage. These
higherfrequency effects generally involve aspects of financial markets closer to market
sentiment. This is particularly evident in the work by Adrian, Boyarchenko and Giannone
(2019). Their research suggests that periods of bullish market sentiment, as potentially
reflected in low credit spreads and low volatility, are often followed by downturns. This
may indicate a risk allocation vulnerability.
Figure 5: A compressed risk premium can hide a buildup of vulnerabilities
3.5
3
2.5
2
High risk premium
percent
1.5
1
premium,
0.5
risk
0
US
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
-0.5
-1
Compressed risk premium
-1.5
Note: Vertical shading shows NBER recession dates.
Source: Excess bond premium of Gilchrist and Zakrajšek (2012)
In Figure 5 we see that before the Great Recession of 2008-09, the pricing of risk, as
captured by credit spreads, was very low. In particular, this figure shows that the
difference in return between risky and safe debt was at a historic low in the United
States between 2003 and 2008, before surging during the recession period of 2008-09.
Figure 6 goes a step further to show that market volatility was lowest in countries that
eventually experienced a banking crisis. As shown in Figure 4b, these are precisely the
countries with high credit growth and lower post-crisis outcomes.8 This illustrates that
excessive market optimism, as captured by credit spreads or volatility, may also be
considered a vulnerability.
Figure 6: Countries that experienced a banking crisis in 2008 had lower volatility before the crisis
2.0
1.8
1.6
percent
1.4
1.2
volatility,
1.0
0.8
realized
0.6
price
0.4
Stock
0.2
0.0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
OECD countries without banking crisis in 2008
OECD countries with banking crisis in 2008
Note: Monthly realized volatility of stock market index returns, detrended from the 10-year moving average. Weighted average using
real GDP. Series smoothed using a yearly moving average.
Sources: Laeven and Valencia (2018), International Monetary Fund and Bank of Canada calculations
Incorporating vulnerabilities: the path ahead
Given the evidence, the Bank of Canada has been tracking financial vulnerabilities for
many years, and we discuss these forces when considering monetary policy. The main
tool we currently use to discuss potential trade-offs associated with financial
vulnerabilities is our growth-at-risk framework, which was first introduced by Adrian,
Boyarchenko and Giannone (2019) and popularized in policy circles by the International
Monetary Fund.9
To understand the growth-at-risk framework, which is somewhat technical, one needs to
imagine the distribution of growth of gross domestic product (GDP) at some time in the
future. Using historical data, we estimate how this distribution shifts in response to
changes in financial vulnerabilities such as the debt-to-GDP ratio. When financial
vulnerabilities increase, this distribution shifts to the left in the manner illustrated by the
dotted or dashed lines in Figure 3. Since we want to be particularly sensitive to bad
economic outcomes, such as recessions, we measure the movement in this distribution
by following its 5th percentile. For example, when accumulated household debt over one
year increases by 100 basis points, the 5th percentile falls by 30 basis points one year
later. That indicates that bad outcomes-if they arise-will tend to be worse when debt
is growing.
How does all this relate to monetary policy? Consider a cut in interest rates. Our
standard models tell us how this will affect economic activity now, and we can also use
these models to help predict how the cut will increase the debt-to-GDP ratio in the
future. Then, by using our growth-at-risk framework, we can quantify the potential
tradeoff associated with monetary policy by simply contrasting the increased growth in the
short run with the worsening of growth at risk in the future. Even if a cut in interest rates
appears desirable in the short run, once we factor in the growth at risk, the cut may no
longer look attractive. It should be emphasized that this approach is not a departure
from our inflation-targeting objective but is simply an added tool to judge the risks to our
inflation outlook further into the future.
While the growth-at-risk framework offers very important insight, we do not see this as
the end state of how we would like to bring financial vulnerabilities into the discussion of
monetary policy. In particular, this framework still involves a large element of judgment,
as many of the relationships are estimated imprecisely. Accordingly, in our current
modelling efforts, we are looking to develop a framework that is more explicit about the
mechanisms at play. One dimension we are particularly interested in exploring relates to
the formation of expectations. Expectations often play a key role in the development of
financial vulnerabilities.
To illustrate, let me focus on house prices. One way interest rate cuts affect economic
activity is by boosting demand for housing. The most desirable outcome in the housing
market is to have the building of new houses follow the fundamental needs of the
economy, which are driven in large part by demographics. However, this is not always
the case. A particular worry in the housing market is that over-optimistic expectations of
house price growth can sometimes arise-people buy houses because they believe
prices will keep rising. That fuels speculative activity, which in turn may lead to
overpriced housing, over-building and an eventual housing bust. In such a case, it is easy to
see how interest rate cuts could lead to the type of boom-bust cycle, or negative
feedback, that I have associated with vulnerabilities.
Now, if everyone in the economy has expectations based only on fundamentals, these
types of outcomes should not arise. But if we want to understand and prepare for such
possibilities, we have to move away from the economic notion of pure rational
expectations and look instead at expectations influenced by learning and psychological
factors. So, while some rational observers might see rising house prices as a symptom
of the market getting ahead of fundamentals, surveys of expectation formation suggest
that many market participants are extrapolating past price growth into the future. In
other words, when they see prices increase, they think prices will keep going up just as
fast. At some point, the prices become so high that houses are no longer affordable and
a reversal in dynamics sets in. Alternatively, an adverse shock to incomes or interest
rates or a change in housing policy could lead to an outsized decline in prices. This is
precisely the type of ingredient that can be dangerous for the economy as a whole. That
is why understanding the process of expectation formation for asset prices is important
for central bankers if we want to better understand how monetary policy may spur
financial vulnerabilities.
Bank staff are also examining how financial vulnerabilities could impact the conduct of
monetary policy by embedding a financial sector into a standard New Keynesian macro
model.10 In the model, accommodative monetary policy not only boosts economic
activity but also encourages greater risk taking in the financial sector. And, if sustained,
increased risk taking ultimately leads to higher vulnerabilities and a more volatile
economy. Monetary policy faces a trade-off in which enhanced macro stabilization today
comes at the cost of less stability down the road. This work will help guide our
discussion on how monetary policy should best manage that trade-off.
How macroprudential and other policies can help monetary policy
When discussing financial vulnerabilities, it is important to recognize the primary role of
macroprudential policies in countering such forces. In particular, since 2008 there have
been important changes to banking regulation, both internationally and domestically,
aimed at mitigating financial vulnerabilities. These changes generally come under the
heading of macroprudential policies. Changes brought by government and regulators
have helped make the financial system more resilient by reducing the potential buildup
of imbalances and by ensuring that financial institutions are capable of absorbing
important shocks. These changes make the choices faced by central banks easier since
the changes directly control vulnerabilities. For example, researchers at the Bank of
Canada have shown how requiring banks to hold more capital during credit expansions,
creating countercyclical capital buffers, substantially stabilizes the economy. This is
illustrated in Figure 7, where staff simulations show that the economy is much more
resilient to shocks with the presence of a capital buffer than without. That makes it
easier to set monetary policy.
In the Figure 7 example, the external shock is an unexpected drop in mortgage rates,
which leads to increased debt and movements in GDP. But with a capital buffer in
place, the response of both debt and GDP is muted.
Figure 7: The countercyclical capital buffer reduces the volatility of both debt and GDP growth
Impulse response to an unexpected drop in mortgage rates
a. Gross domestic product b. Household debt
Deviation from
Deviation from
2 steady state,
steady state, 2
15
15
percent
percent
1 1
10
10
0 5
0 5
-1 0
-1 0
0 5 10 15 20
0 5 10 15 20
Quarters
Quarters
Source: Bank of Canada calculations using the MP2 model of Alpanda, Cateau and Meh (2018)
Given that macroprudential policy is a tool aimed at directly tackling financial
vulnerabilities, it is sometimes argued that monetary policy should not focus on such
forces at all. This challenge, it is argued, should be left entirely to macroprudential
authorities. While macroprudential policies should be the first line of defence, especially
when a central bank has limited tools, it may be overly simplistic to think that monetary
policy need not worry about financial vulnerabilities. As long as interest rate policies
may affect the buildup of financial vulnerabilities, an inflation-targeting central bank may
need to worry about such forces and act in a manner that complements macroprudential
policies. Even if macroprudential policy is best suited to ensure the resilience of the
financial system, that does not mean it is capable of eliminating all the risks associated
with financi