Household debt, monetary policy and financial stability: still searching for a unifying model

April 2008

Abstract

Secular increases in household debt have been experienced across a wide range of economies in Asia and the Pacific as well as elsewhere. In many cases, this has reflected the deepening of financial markets and, in particular, the ability of households to tap human and non-human wealth in ways that had not previously been available. Several key policy questions arise from such developments. Do the trends represent a key source of risk to the macroeconomy (and how best can these issues be modeled)? What is the appropriate policy regime to address the new environment? And, in particular, how should central banks react as vulnerabilities rise and as worst case scenarios materialize? At their heart, these questions raise complex issues associated with the nexus between monetary and financial stability. To shed some light on the current debate, this paper offers a monetary policy perspective on these issues by offering a pedagogical monetary policy model that features the interplay of asset price bubbles and household debt, by discussing how to extend the model to incorporate financial stability issues and by arguing that central banks can, and in many cases should, incorporate the information about household debt in setting policy rates and in assessing the policy risks.