Monetary Tightening, Quantitative Easing, and Financial Stability

This paper analyses the implications of central bank balance sheet policies on financial stability in a framework with banks facing occasionally-binding leverage constraints and endogenous disruptions in financial intermediation. Whilst central bank balance sheet expansions are effective in stabilising the economy in a financial stress episode, they increase the frequency of such episodes and their duration. Balance sheet expansions induce financial intermediaries to take on more risk in normal times and slow their recapitalisation during a stress episode. In a tightening cycle, stabilisation properties of balance sheet policies are maintained but come at a significant cost to price stability.