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Optimal Monetary and Prudential Policies

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Author Info

  • Fabrice Collard

    ()
    (University of Bern)

  • Harris Dellas

    ()
    (University of Bern)

  • Behzad Diba

    ()
    (Georgetown University)

  • Olivier Loisel

    ()
    (CREST(ENSAE))

Abstract

The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability and has raised the question of whether and how to combine the corresponding main policy instruments (interest rate and bank-capital requirements). This paper offers a characterization of the jointly optimal setting of monetary and prudential policies and discusses its implications for the business cycle. The source of financial fragility is the socially excessive risk-taking by banks due to limited liability and deposit insurance. We characterize the conditions under which locally optimal (Ramsey) policy dedicates the prudential instrument to preventing inefficient risk-taking by banks; and the monetary instrument to dealing with the business cycle, with the two instruments co-varying negatively. Our analysis thus identifies circumstances that can validate the prevailing view among central bankers that standard interest-rate policy cannot serve as the first line of defense against financial instability. In addition, we also provide conditions under which the two instruments might optimally co-move positively and countercyclically.

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Bibliographic Info

Paper provided by Centre de Recherche en Economie et Statistique in its series Working Papers with number 2012-34.

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Length: 35
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:crs:wpaper:2012-34

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Keywords: Prudential policy; Capital requirements; Monetary policy; Ramsey-optimal policies;

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References

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  1. Christopher Otrok & Gianluca Benigno & Huigang Chen & Alessandro Rebucci & Eric R. Young, 2012. "Monetary and Macro-Prudential Policies: An Integrated Analysis," Working Papers 1208, Department of Economics, University of Missouri.
  2. Javier Bianchi & Enrique G. Mendoza, 2011. "Overborrowing, Financial Crises and 'Macro-prudential' Policy," 2011 Meeting Papers 175, Society for Economic Dynamics.
  3. Borio, Claudio & Zhu, Haibin, 2012. "Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?," Journal of Financial Stability, Elsevier, vol. 8(4), pages 236-251.
  4. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  5. Ian Christensen & Césaire Meh & Kevin Moran, 2011. "Bank Leverage Regulation and Macroeconomic Dynamics," Cahiers de recherche 1140, CIRPEE.
  6. Martinez-Miera, David & Suarez, Javier, 2012. "A Macroeconomic Model of Endogenous Systemic Risk Taking," CEPR Discussion Papers 9134, C.E.P.R. Discussion Papers.
  7. Vasco Cúrdia & Michael Woodford, 2010. "Conventional and unconventional monetary policy," Review, Federal Reserve Bank of St. Louis, issue May, pages 229-264.
  8. Francisco Covas & Shigeru Fujita, 2010. "Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence," International Journal of Central Banking, International Journal of Central Banking, vol. 6(34), pages 137-173, December.
  9. David Lopez-Salido & Andrew T. Levin, 2004. "Optimal Monetary Policy with Endogenous Capital Accumulation," 2004 Meeting Papers 826, Society for Economic Dynamics.
  10. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 16270, University Library of Munich, Germany.
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Citations

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Cited by:
  1. Dominic Quint & Pau Rabanal, 2014. "Monetary and Macroprudential Policy in an Estimated DSGE Model of the Euro Area," International Journal of Central Banking, International Journal of Central Banking, vol. 10(2), pages 169-236, June.
  2. guo, min & zhao, jizhi, 2013. "最优货币政策和最优金融稳定政策的一般均衡分析
    [General equilibrium analysis of the optimal monetary policy and the optimal financial stability policy]
    ," MPRA Paper 48143, University Library of Munich, Germany.
  3. Bianca De Paoli & Matthias Paustian, 2013. "Coordinating monetary and macroprudential policies," Staff Reports 653, Federal Reserve Bank of New York.
  4. Thorsten Beck & Andrea Colciago & Damjan Pfajfar, 2014. "The role of financial intermediaries in monetary policy transmission," DNB Working Papers 420, Netherlands Central Bank, Research Department.
  5. Gianluca Benigno, 2013. "Commentary on Macroprudential Policies," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 287-297, March.

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