DP11739 | Cost-Benefit Analysis of Leaning Against the Wind

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01/03/2017

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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.