1. Consider the price stability-financial stability (PS-FS) model in which the Bank of England is required to meet both an inflation target and a credit growth target. Illustrate your answers using graphical analysis.
a) Suppose the economy enters a period of excessive optimism, in which inflation is rising and credit growth is surging. How do the PS and FS curves shift? How can the Bank of England meet its credit growth target if it controls monetary policy?
b) Suppose the economy experiences a beneficial supply shock, in which inflation is falling and credit growth is surging but still below the maximum growth rate consistent with financial stability. How do the PS and FS curves shift? How can the Bank of England meet its inflation target if it controls monetary policy?
c) Suppose that credit growth is surging but the Bank of England cannot tell whether inflationary pressures are rising or falling. Assume its key priority is to prevent an asset price bubble from forming. What risks does it face if controlling monetary policy alone, given that it does not know whether the credit growth surge is due to an asset price bubble or an improvement in economic fundamentals? How might these risks be mitigated if it controls both monetary policy and macroprudential policy?
d) Suppose the economy experiences a severe adverse shock to consumer confidence, warranting an aggressive monetary easing so that the policy rate reaches the zero lower bound (ZLB). How might the use of macroprudential tools provide additional economic stimulus under these conditions?