Central Banks and the Financial System

Financial systems are inherently fragile because of the very function which makes them valuable: liquidity transformation. Regulatory reforms can strengthen the financial system and decrease the risk of liquidity crises, but they cannot eliminate it completely. This leaves monetary policy with a very important task. In a framework that recognizes the interactions between monetary policy and liquidity transformation 'optimal' monetary policy would consist of a modified Taylor rule in which the real rate reflects the possibility of liquidity crises and recognizes the possibility that liquidity transformation gets subsidized. Failure to recognize this point risks leading the economy into a low interest rate trap: low interest rates induce too much risk taking and increase the probability of crises. These crises, in turn, require low interest rates to maintain the financial system alive. Raising rates becomes extremely difficult in a severely weakened financial system, so monetary authorities remain stuck in a low interest rates trap. This seems a reasonable description of the situation we have experienced throughout the past decade.