The Interaction of Monetary and Macroprudential Policies in the Presence of Financial Frictions

In this paper, the interaction and cooperation of different specifications of monetary and macroprudential policies are assessed using a dynamic stochastic general equilibrium model with stylised banking sector, financial frictions, and endogenous defaults. The effectiveness of cooperation is assessed using a second-order welfare analysis. The model is re-estimated to fit the relevant data and produce accurate results. Robustness analysis is undertaken to evaluate policies, while considering an occasionally binding borrowing constraint. The results suggest that, in general, cooperation leads to improved welfare. However, in the presence of an incomplete pass-through of policy rates in a stylised banking sector, all macroprudential policies that act through banks prove less effective than policies that directly affect agents’ marginal decisions. Nevertheless, a ‘lean against the wind’ policy augmented by borrowings tends to provide a ‘golden balance’ between policies and can therefore be used by the authorities as a universal tool to mitigate economic and financial instability.