Can We Still Lean Against the Wind?

In an overlapping generations model without financial frictions, Gali (Am Econ Rev 104(3):721–752, 2014) observed that a ‘leaning against the wind’ monetary policy is likely to aggravate the fluctuations in the bubble. He found that optimal monetary policy in such an economy must strike a balance between stabilization of the bubble and stabilization of aggregate demand. This paper extends Gali (Am Econ Rev 104(3):721–752, 2014)’s model by introducing various financial frictions in the bubbly economy with a Samuelson 2-period overlapping agents and examine how ‘leaning against the wind’ macro-prudential policies like capital adequacy affect the size and volatility of bubble, inflation and aggregate demand. While the results of the model with financial frictions vindicate Gali (Am Econ Rev 104(3):721–752, 2014) that a leaning against the wind monetary policy generates a larger volatility in the bubble than a policy of benign neglect, the paper finds that minimisation of bubble volatility requires an active macro-prudential policy. It is also observed that stronger interest rate response of monetary policy to the bubble necessitates a stronger macroprudential response possibly to absorb the excess volatility generated by the monetary policy. However, the paper also finds that tightening macroprudential policy parameter beyond a threshold value may encourage banks to take more risks and increase credit supply, aggravating the bubble in the process. With respect to macroprudential policy, there is no conflict between stabilization of current aggregate demand and stabilization of future aggregate demand and both call for a strong macroprudential response, at least until the macroprudential parameter attains the threshold value, although the conflict between the two objectives persists with respect to monetary policy as in Gali (Am Econ Rev 104(3):721–752, 2014). Empirical verification of the provisioning cost channel through structural vector autoregression confirm that a positive provisions shock can contract asset bubbles by restricting credit, output and a delayed marginal response of interest rate spreads.