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Can LAW be justified to prevent financial instability? A cost-benefit analysis of leaning against the wind (LAW) in Norway : Evidence from a Bayesian VAR model

Fossan, Andreas Habtamu; Friestad, Lars
Master thesis
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URI
https://hdl.handle.net/11250/3050646
Date
2022
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  • Master Thesis [4657]
Abstract
Since the 2008 Global Financial Crisis, there has been an ongoing debate about how central

banks can prevent future financial crises by mitigating the build-up of financial imbalances.

We analyse the effect of incorporating financial stability considerations through monetary

policy by "leaning against the wind" (LAW), which involves keeping a slightly tighter

monetary policy for the purpose of mitigating financial instability. The benefits of LAW

are lower probability and severity of a financial crisis in the future, while the cost is higher

unemployment.

We model LAW as a one-time monetary policy shock using a structural Bayesian VAR

model on Norwegian data, inspired by Robstad (2018). Then, we analyse the cost-benefit

trade-off of LAW in Norway using a modified version of the framework in Svensson (2017a),

and contribute to the literature by including house price growth as an indicator explaining

the probability of a crisis. We find that LAW is clearly unjustified when using household

credit growth as an indicator of financial instability. This conclusion also is robust to any

reasonable changes in the underlying estimates and assumptions. When using house price

growth, we actually find that LAW is justified in the benchmark model, although only by

a very small margin. However, this conclusion is not at all robust, as reasonable changes

to the underlying estimates and assumptions easily change the conclusion, making LAW

unjustified. Hence, we cannot use this result to conclude that LAW is an advisable policy

in Norway.

In sum, the numerical results do not find evidence that LAW is justified in Norway.

Furthermore, Norway has a well-equipped macroprudential policy toolkit to counteract

financial imbalances, arguably reducing the effect of and need for LAW. We therefore

recommend that Norges Bank should not "lean against the wind", unless the Norwegian

economy experiences extraordinary circumstances where the macroprudential policy tools

clearly are insufficient to secure financial stability.

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