Optimal Interest Rate Tightening with Financial Fragility

IMF Working Papers, January 31, 2025

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Monetary tightening exacerbates financial stress after supply shocks through declines in asset prices, bank equity and increased run risks.
Empirical evidence in the paper supports the link between interest rate tightening and amplified financial stress following supply shocks.
When intermediaries’ equity is sufficiently low, interest rate tightening lowers asset prices and exacerbates financial distortions.

The paper develops a tractable model with:
- Intermediaries that face occasionally binding leverage constraints and endogenous risks of runs.
- Producers that face price adjustment frictions.
Mechanism: Interest rate tightening lowers asset prices, which intensifies leverage constraints and run risks when bank equity is low.

The model is used to characterize constrained efficient use of policy instruments during periods of supply-driven inflation and financial fragility:
- Interest rate policy (monetary policy tightening)
- Credit policy
- Equity injection
- Macroprudential policy
- Deposit insurance
Key normative insights:
- When other tools are costly, optimal monetary policy tightening should be less aggressive in the presence of financial fragility.
- If other tools were not costly, an appropriate combination of tools could perfectly separate financial stability from price stability objectives.