o. gervais and m. - a. gosselin, “ analyzing and forecasting the canadian economy through the lens model, ” technical report no. 102, bank of canada, 2014. bis central bankers ’ speeches on the benefits side, they estimated that increasing the bank ’ s policy rate by 1 percentage point for one year would reduce real household debt by 2 per cent over five years. 5 everything else being equal, less household debt reduces the vulnerability of the economy and the financial system ; the results, however, suggest that this difference may be very small. on the cost side, the same increase in the policy rate might cut output by up to 1 per cent and push inflation down by 0. 5 percentage point relative to what it would have been otherwise. while, like any empirical results, these findings are a product of the methodology used, it is noteworthy that they are consistent across standard models – and indeed, similar results have been found using broadly similar approaches in other countries. these results suggest that, even though monetary policy could, in principle, be used to reduce vulnerabilities in the financial system, it may be too costly in practice. interest rates affect all parts of the economy and are too blunt an instrument to address an imbalance in just one part of the economy – household credit. if you have a specific imbalance, you need a specific tool to address it. the analysis relies on a number of assumptions about how monetary policy affects debt and how debt affects financial stability. the relationship between monetary policy and financial stability may depend on the specific economic conditions in which we find ourselves. 6 moreover, the processes resulting in financial cycles, with periods of unsustainable debt buildup, occasional crises and periods of deleveraging, are not well captured by standard models. 7 we have more work to do before we can be fully confident about our conclusions. here, i would like to focus on one critical aspect of the discussion : that monetary policy can affect financial stability only through its effects on household debt, even though it affects a wide swath of the real economy. however, we also need to envisage a case where the effects of monetary policy on financial stability are not limited to one sector, as in the case we just saw, but spread across many different parts of the financial system. in that case, monetary policy ’ s ability to get in all the cracks of the financial system – to paraphrase former federal reserve governor jeremy stein – would give

the best – or even the only – contribution monetary policy can make to promoting a country ’ s economic and financial well - being. the inflation - targeting regime we have today is an outgrowth of that experience. inflation targets have been very successful at maintaining price stability because they give everyone an easy way to understand monetary policy and, over time, create a virtuous circle in which realized inflation and expectations reinforce each other. a central tenet of the framework is that a central bank uses the policy interest rate solely to counter risks to inflation. if it tried to do other potentially conflicting things, such as keeping unemployment artificially low or containing volatility in the financial markets, its credibility could erode, the virtuous circle could break down and inflation could go back to being unpredictable. the question of whether central banks can use monetary policy to promote financial stability as well as price stability has re - emerged from time to time. it has often been couched in terms of using monetary policy to prevent or deflate asset - price bubbles – perhaps to dampen irrational exuberance in stock markets. but the question is really more general, related to the use of monetary policy in countering an excessive buildup of leverage in the economy. identifying such financial imbalances is not as straightforward as it sounds, and using monetary policy to address them was seen as a potential distraction from the task of targeting inflation. moreover, during the great moderation, such imbalances were not seen as a serious obstacle to stabilizing the economy. confronted with the choice of whether to “ lean ” or to “ clean ” – leaning against emerging financial imbalances by keeping interest rates higher than they otherwise would be or cleaning up in the event the risks they create are realized by providing stimulus – central bankers at that time generally agreed that cleaning would be best. that consensus was shattered by the global financial crisis. unlike past episodes in recent history, the crisis began in the world ’ s most sophisticated financial systems, causing widespread economic devastation. it stirred up persistent and formidable headwinds to economic growth, also making it very difficult for central banks to bring inflation back to target. after this brutal wakeup call, economists went back and re - examined the possible role monetary policy plays in setting the stage for crises. looking at the historical evidence, it would be fair to conclude that few, if any, crises have been caused by monetary policy alone. the global financial crisis, like the great crash of 1929, also