How central banks spurred a financial crisis

Inflation targeting, used widely by central banks, led to excessive credit growth, debt accumulation, financial instability and the subsequent financial crisis.

As numerous studies over the last two decades have shown, interest rate policies of a large number of central banks can be explained by the so-called Taylor Rule. According to this rule, which is consistent with inflation targeting, the policy rate is determined by a neutral real rate, the target inflation rate, the output gap, and the deviation of inflation from the target (or expected) rate. In this formula, the output gap can be interpreted as a leading indicator for inflation, as suggested by an augmented Phillips-curve inflation model, where the deviation of actual inflation from the target has the character of an error-correction term.

There is no room for financial variables, such as money, credit, or asset prices, in this policy rule.

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