The regional and international financial instability that we have experienced recently is a stark reminder of the limits of an aggressive tightening of monetary policy. If balance sheets and debt services are sensitive to changes in interest rates, a rapid increase in the policy rate runs into a financial-stability barrier.

This point has been made many times by economists who reject the validity of the “Schwartz Hypothesis”, which states that by focusing on price stability a central bank also promotes financial stability and “will do more for financial stability than reforming deposit insurance or reregulating” (Schwartz 1988, 55). Contrary to such a hypothesis, many economists have emphasized the destabilizing effect of an aggressive monetary policy. John Maynard Keynes’s square rule, what is now known as the “liquidity trap”, noted the duration risk involved in aggressive monetary policy. Hyman P. Minsky from the 1960s argued that active monetary policy must be conditional on the state of fragility of the financial system (e.g., Minsky 1964, 1972, 1975). Nicholas Kaldor concluded that “there must clearly be limits to the freedom of the central bank to use the interest weapon if the solvency and viability of financial institutions is to be preserved” (Kaldor 1982, 13). The point was further emphasized and developed by post-Keynesians and generated a vigorous debate among proponents of the Inflation Targeting framework (Tymoigne 2009a, 2009b).