Monetary policy and macro-prudential regulation: the risk-sharing paradigm

Abstract

How should monetary policy and macro-prudential regulation respond to the dangers of financial bubbles? I argue that bubbles - and their collapse - become a serious problem when there is inadequate risk-sharing. Neither monetary policy nor traditional macro-prudential regulation is designed to deal with this risk-sharing problem. Monetary policy has little hope of either accurately anticipating bubbles or dealing effectively with their consequences. Traditional approaches to macro-prudential regulation are unlikely to succeed as they are based on the false premise that risk can always be quantified up front. I propose considering "ex-ante flexible contracting" as a longer-term response to the financial stability question.