Integrating financial stability: new models for a new challenge, by Stephen G Cecchetti, Piti Disyatat and Marion Kohler, 14 September 2009. This essay was prepared for the joint BIS-ECB Workshop on “Monetary policy and financial stability”, Basel, Switzerland, 10-11 September 2009.
“Reflecting on the financial crisis that is not yet over, it is natural to ask whether our macroeconomic models are still relevant. For all of their elegance and beauty, with their microeconomic foundations and complex endogenous dynamics, they provided the basis for monetary policy that delivered a quarter of a century of stability. The Great Moderation was great – inflation was low, growth was high, and both were stable. At least, that’s what we thought. In retrospect, signs of smugness abounded. Academic journals are filled with papers explaining that this stability was, in large part, a result of good policy. And policymakers listened. The economy was inherently stable, with strong self-correcting forces. The financial crashes that were so common before the mid-20th century were banished by our deep and profound understanding that had been translated into mathematical models.”
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