Working Paper: NBER ID: w21902
Authors: Lars E.O. Svensson
Abstract: A simple and transparent framework for cost-benefit analysis of \\leaning against the wind" (LAW), that is, tighter monetary policy for financial-stability purposes, is presented. LAW has obvious costs in the form of a weaker economy if no crisis occurs and possible benefits in the form of a lower probability and smaller magnitude of (financial) crises. A second cost—less obvious, overlooked by previous literature, but higher—is a weaker economy if a crisis occurs. For representative empirical benchmark estimates and reasonable assumptions the result is that the costs of LAW exceed the benefits by a substantial margin. The result is robust to alternative assumptions and estimates. A higher probability, larger magnitude, or longer duration of crises—typical consequences of ineffective macroprudential policy—all increase the margin of costs over benefits. To overturn the result, policy-interest-rate effects on the probability and magnitude of crises need to be more than 5–40 standard errors larger than the benchmark estimates.
Keywords: Cost-benefit analysis; Monetary policy; Financial stability
JEL Codes: E52; E58; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Law (tighter monetary policy) (E49) | Weaker economy (higher unemployment, lower inflation) (E31) |
| Law (K36) | Higher cost of crisis (crisis loss) (H12) |
| Law (K36) | Lower probability of crisis (H12) |
| Law (K36) | Smaller magnitude of crisis (H12) |