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How to Manage Macroeconomic and Financial Stability Risks: A New Framework

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Financial system vulnerabilities increase the downside risk to future GDP growth. Downside risk is measured by GDP at risk—the growth rate of GDP that should be exceeded in all but the worst 5 per cent of expected outcomes.

Managing risks around future GDP growth is important for financial stability purposes. Financial stability risks reflect how much worse GDP growth could be relative to the most likely outcome. We define financial stability risk as the distance of GDP at risk from the median outlook for GDP growth.

Monetary policy faces a trade-off between financial stability and macroeconomic risks. In an economy that is close to potential and exhibits elevated vulnerabilities, raising rates reduces financial stability risks but slows GDP growth, therefore increasing macroeconomic risks.

Macroprudential tightening significantly reduces financial stability risks as vulnerabilities decrease. Without the macroprudential tightening in 2018, monetary policy would have faced a tougher trade-off.