Dr Rajan, who himself has been IMF's Chief Economist and is among the few to have rightly predicted the financial crisis of 2007, has triggered a debate among policymakers and economists with his warning against central banks globally being pushed into "competitive monetary policy easing".
In an address at the London Business School, Dr Rajan went even further and warned that the global economy was "slowly slipping" into the Great Depression-like problems of the 1930s and the central banks need to sit together and define new "rules of the game" to find a better solution to deal with it.
Dr Rajan also said it's a problem of collective action and not a problem of industrial nations or emerging markets.
Countering his views, the IMF Working Paper now says the monetary policy easing alone cannot be blamed for the financial instability and the bigger cause for the global recession in the past, including in 2007-09, has been the "absence of an effective regulatory framework aimed at preserving financial stability".
The IMF Working Paper, authored by Bank of England Economist Ambrogio Cesa-Bianchi and Alessandro Rebucci of John Hopkins University, has made this conclusion after studying the global financial crisis of 2007-09 and the role of policies for stability of the financial system or the economy as a whole at that time.
"In advanced economies, this debate is revolving around the role of monetary and regulatory policies in causing the global crisis and how the conduct of monetary policy and the supervision of financial intermediaries should be altered in future to avoid the recurrence of such a catastrophic event," the two authors wrote in the paper authorised by the IMF's Research Department.
The two economists agreed that the monetary policy can affect financial stability, for which they have cited a research paper authored by Dr Rajan in 2005, but argued that an effective regulatory mechanism can counter-balance this.
Incidentally, it was this Working Paper on 'Has financial development made the world riskier', wherein the Dr Rajan had warned against an impending financial crisis and had said that "economies may be more exposed to financial sector-induced turmoil than in the past".
"One last ingredient can make the cocktail particularly volatile, and that is, low interest rates after a period of high rates - either because of financial liberalisation or because of extremely accommodative monetary policy," Dr Rajan had said at that time, but his warnings were dismissed by the most and some even called him "Luddite" for airing such views.
In their latest IMF Paper, the two economists said some observers have assigned to monetary policy a key role in exacerbating the severity of the global financial crisis of 2007-09.
"Despite a somewhat widely shared common sentiment that the Federal Reserve is partly to blame for the housing bubble, the issue is highly controversial in academia and the policy community," they said.
While some observers support the idea that monetary policy contributed significantly to the boom that preceded the global financial crisis, others argue against this thesis.
"To address some of these issues, we developed a simple model of consumption-based asset pricing with collateralized borrowing, monopolistic banking, real interest rates rigidities and pecuniary externalities," they said.
The first argument - that higher interest rates would have reduced both the probability and the severity of the great recession - is justified only with an "auxiliary assumption that the Fed had to address all distortions in the economy with only one instrument, namely the policy interest rate".
Under former Chairman Alan Greenspan, the US Federal Reserve lowered its benchmark rate from 6.5 per cent to about 2 per cent in 2000-01 as a response to the burst of the dot-com bubble. It further lowered rates to 1 per cent in 2002-03 in response to a deflationary scare, and finally started a long sequence of tightening actions that, during 2004-06, brought the rate back to 5 per cent.
It has been argued that the Fed helped inflate US housing prices by keeping rates too low for too long after 2002 and as a consequence, those low rates were a factor in the housing boom and therefore, ultimately the bust.
"Therefore, according to this view, higher interest rates would have reduced both the probability and the severity of the bust that led to the Great Recession," the Paper said.
However, this contention that "excessively lax monetary policy might have contributed to the occurrence and the severity of the Great Recession" does not appear justified.
While the monetary policy was appropriately targeting macroeconomic stability, the regulatory function of the system, instead, was "at best ineffective in addressing the financial imbalance that continued to grow in the subprime mortgage market while monetary policy was tightened in 2004-05", the two economists said.
"With the fall in interest rates after the burst of the dot-com bubble and with house prices at bubble-inflated levels, the mortgage industry found creative ways to expand lending and make large profits.
"Government regulators maintained a hands-off approach for too long... policy measures aimed at tightening a largely unregulated sector of the US mortgage market kicked in much later than the tightening of monetary policy enacted by the Federal Reserve," they wrote in their Paper.
The two concluded that the interest rates can be lowered as much as needed in response to a contractionary shock without concerns for financial stability, when the policy authority has two different instruments.
"This is consistent with the view of (former Fed Chairman Ben) Bernanke that additional policy tools, to limit dangerous expansions in leverage, were needed to prevent the global financial crisis," they added.