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Optimal Monetary and Macroprudential Policies

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  • Josef Schroth

Abstract

This paper studies monetary policy in an economy where banks make risky loans to firms and provide liquidity services in the form of deposits to households. For given bank equity, market discipline implies that banks can take more deposits when assets are safer or more profitable. Banks respond to loan losses by making their balance sheets safer—i.e., they reduce risky lending sharply and accumulate more safe bonds. In contrast, a social planner would respond by making banks temporarily more profitable such that a riskier balance sheet can be maintained. A planner would temporarily reduce the expansiveness of monetary policy to avoid bonds becoming too liquid in support of the liquidity premium banks earn via deposits. Specifically, when bank equity is low, then optimal monetary policy stabilizes output by supporting bank lending rather than employment.

Suggested Citation

  • Josef Schroth, 2021. "Optimal Monetary and Macroprudential Policies," Staff Working Papers 21-21, Bank of Canada.
  • Handle: RePEc:bca:bocawp:21-21
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit and credit aggregates; Financial stability; Financial system regulation and policies; Inflation targets; Monetary policy;
    All these keywords.

    JEL classification:

    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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