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Monetary policy and capital regulation in the US and Europe

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  • Cohen-Cole, Ethan
  • Morse, Jonathan

Abstract

From the onset of the 2007-2009 crisis, the Federal Reserve and the European Central Bank have aggressively lowered interest rates. Both sets of changes are at odds with an anti-inflationary stance of monetary policy; indeed, as the crisis began in August 2007 inflation expectations were high and rising, particularly in the United States. We have two additions to the literature. One, we present a model economy with a leveraged and regulated financial sector. Two, we find optimal Taylor rules for our economy that are consistent with a strong pro-inflationary reaction during financial crisis while maintaining a standard output-inflation mandate. We have three interpretations of our results. One, because the Federal Reserve has partial control over bank regulation it can exercise regulatory lenience. Two, the Fed's stronger output orientation means that it will potentially respond more quickly when faced with constrained banks. Three, our results support procyclical capital regulation. JEL Classification: E52, E58, G18, G28

Suggested Citation

  • Cohen-Cole, Ethan & Morse, Jonathan, 2010. "Monetary policy and capital regulation in the US and Europe," Working Paper Series 1222, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20101222
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    References listed on IDEAS

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    5. Gordy, Michael B. & Howells, Bradley, 2006. "Procyclicality in Basel II: Can we treat the disease without killing the patient?," Journal of Financial Intermediation, Elsevier, vol. 15(3), pages 395-417, July.
    6. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
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    8. Faia, Ester & Monacelli, Tommaso, 2007. "Optimal interest rate rules, asset prices, and credit frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3228-3254, October.
    9. Fiorella De Fiore & Oreste Tristani, 2013. "Optimal Monetary Policy in a Model of the Credit Channel," Economic Journal, Royal Economic Society, vol. 123(571), pages 906-931, September.
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    Citations

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    Cited by:

    1. Dalla Pellegrina, L. & Masciandaro, D. & Pansini, R.V., 2013. "The central banker as prudential supervisor: Does independence matter?," Journal of Financial Stability, Elsevier, vol. 9(3), pages 415-427.
    2. Carla Soares & Isabel Gameiro & João Sousa, 2011. "Monetary policy and financial stability: an open debate," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    3. Lucia Dalla Pellegrina & Donato Masciandaro & Rosaria Vega Pansini, 2011. "New Advantages of Tying One’s Hands: Banking Supervision, Monetary Policy and Central Bank Independence," Chapters, in: Sylvester Eijffinger & Donato Masciandaro (ed.), Handbook of Central Banking, Financial Regulation and Supervision, chapter 8, Edward Elgar Publishing.

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    More about this item

    Keywords

    capital regulation; crisis; monetary policy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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