There are two reasons why financial stability is — or should be — a central bank’s primary objective. For starters, the economic damage caused by a financial crisis can easily dwarf the losses stemming from a broader business-cycle downturn. Second, financial stability is itself a necessary condition for macroeconomic stability more generally. Obviously, financial explosions and implosions are not particularly conducive to the pursuit of stable prices and full employment.
(Dec 27): Most modern central banks regard macroeconomic stability — meaning price stability or, in some cases, price stability alongside full employment — as their main goal. But the Bank of Japan and the European Central Bank seem to be running out of tools with which to pursue this goal effectively. And the Bank of England and the US Federal Reserve could soon find themselves in a similar position. Whenever the next cyclical downturn arrives, the effective lower bound on the policy rate will once again become a binding constraint on monetary policymaking (a situation known as a “liquidity trap”).
That’s the bad news. The good news is that the major central banks are still adequately equipped to achieve their single-most important objective: financial stability. When the next financial crisis hits, central banks should still be able to provide sufficient emergency funding liquidity as the lenders of last resort (LLR), and emergency market liquidity as the market makers or buyers of last resort (MMLR).
