Such a view ran counter to that espoused by many central bankers, most notably Federal Reserve Chairman Alan Greenspan, who questioned the feasibility of addressing such financial imbalances with preemptive monetary policy; in his view, monetary policy should instead focus on minimising the fallout from any subsequent correction – the so-called “cleaning” approach. 4 While the logic of leaning against the wind is sound in principle, the key question is whether a monetary tightening of plausible magnitude is likely to be effective in attenuating an established credit boom. Even if policy rates may appear with hindsight to have been held too low for too long in the years preceding the crisis, particularly in the United States, the empirical evidence suggests that they would need to have been significantly higher to have had a meaningful impact on the rate of credit expansion. 5 It is a brave central banker who would deliberately induce a recession in order to head off the mere risk of a future financial correction. 3  For instance, William White (2006), “Is price stability enough?”, Bank for International Settlements Working Paper 205. 4  Alan Greenspan (2002), “Opening Remarks” in Rethinking Stabilization Policy, Federal Reserve Bank of Kansas. 5  Charles Bean, Matthias Paustian, Adrian Penalver and Tim Taylor (2010), “Monetary Policy after the Fall” in Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas.
The respective slopes of these two schedules depend on the relative impact of the policy rate and the macroprudential tool on aggregate demand and on the quantity of credit. A well-chosen and well-designed macroprudential tool is one that has a relatively large effect on the quantity of credit but only a modest impact on aggregate demand. That would generate a relatively flat FS schedule. Moreover, since changes in policy rates also affect aggregate demand through routes other than the credit channel, such as the exchange rate, it seems reasonable to assume that the PS schedule is relatively steep. That is the configuration of relative slopes shown in the Chart. Provided the two schedules do not coincide, both price and financial stability objectives can be achieved simultaneously. With this configuration, it is natural to assign the monetary instrument to the pursuit of price stability and the macroprudential instrument to the pursuit of financial stability. Moreover, with these slopes and this assignment, no active co-ordination in the setting of the instruments is strictly necessary: a process whereby each instrument is set independently, taking the other as given would converge on the equilibrium, A. That said, appropriate co-ordination and information exchange is desirable to achieve it efficiently and is facilitated in the real world by housing the MPC and the FPC in the same institution, with overlapping memberships, and the scope to meet jointly when required. Some sorts of shocks will involve a tightening in both instruments.