Financial Cycles and Monetary Policy

Before the Global Financial Crisis, in both the dominant view and the econometric models used by central banks, finance was considered as being peripheral to the macroeconomic cycle. Borio and other scholars working at the Bank for International Settlements (BIS) made a major contribution to the theory of financial crises by highlighting how a financial cycle can impact on real variables. In particular, when a financial cycle overlaps with an expansive real cycle, banks may underestimate credit risk leading to a real estate and/or financial bubble that in the end may result in a financial crisis. The importance given by Borio to the financial cycle led him to suggest that monetary policy should support macroprudential policies aimed at ensuring financial stability.