IMF Working Papers

Optimal Interest Rate Tightening with Financial Fragility

By Damien Capelle, Ken Teoh

January 31, 2025

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Format: Chicago

Damien Capelle, and Ken Teoh. "Optimal Interest Rate Tightening with Financial Fragility", IMF Working Papers 2025, 035 (2025), accessed April 15, 2025, https://doi.org/10.5089/9798400299094.001

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Recent events have reignited concerns about the financial stability implications of monetary policy. We show empirically that monetary tightening exacerbates financial stress after supply shocks, through declines in asset prices, bank equity and increased run risks. We then develop a tractable model in which intermediaries face occasionally binding leverage constraints and endogenous risks of runs, while producers face price adjustment frictions. Interest rate tightening, by lowering asset prices, exacerbates both financial distortions when intermediaries’ equity is sufficiently low. We use the model to characterize the constrained efficient use of interest rate policy, credit policy, equity injection, macroprudential policy and deposit insurance during periods of supply-driven inflation and fragility. When other tools are costly, optimal monetary policy tightening should be less aggressive in the presence of financial fragility. If other tools were not costly, the right combination of tools could perfectly separate financial stability from price stability objectives.

Subject: Asset prices, Central bank policy rate, Credit, Deposit insurance, Financial crises, Financial sector policy and analysis, Financial sector stability, Financial services, Financial statements, Inflation, Money, Prices, Public financial management (PFM)

Keywords: Asset prices, Central bank policy rate, Credit, Deposit insurance, Financial panics, Financial sector stability, Financial stability, Financial statements, Global, Inflation, Monetary policy

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