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A Theory of Macroprudential Policies in the Presence of Nominal Rigidities

Listed author(s):
  • Emmanuel Farhi
  • Ivan Werning

AbstractWe provide a unifying foundation for monetary policy and macroprudential policies in financial markets for economies with nominal rigidities in goods and labor markets and constraints on monetary policy such as the zero lower bound or fixed exchange rates. Macroprudential interventions in financial markets are beneficial because of an aggregate demand externality. Ex post, the distribution of wealth across agents affects aggregate demand and output through Keynesian channels. However, ex ante, these effects are not privately internalized in the financial decisions agents make. We obtain a simple formula that characterizes the size and direction for optimal financial market interventions as a function of a small number of empirically measurable sufficient statistics. We also characterize optimal monetary policy. We then show how to extend our framework to also incorporate financial markets frictions giving rise to pecuniary externalities. Finally, we provide a number of relevant concrete applications of our general theory.

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File URL: http://scholar.harvard.edu/farhi/node/95131
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Paper provided by Harvard University OpenScholar in its series Working Paper with number 95131.

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Handle: RePEc:qsh:wpaper:95131
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  1. Martin L. Weitzman, 1974. "Prices vs. Quantities," Review of Economic Studies, Oxford University Press, vol. 41(4), pages 477-491.
  2. Jeremy C. Stein, 2012. "Monetary Policy as Financial Stability Regulation," The Quarterly Journal of Economics, Oxford University Press, vol. 127(1), pages 57-95.
  3. Veronica Guerrieri & Guido Lorenzoni, 2011. "Credit Crises, Precautionary Savings, and the Liquidity Trap," NBER Working Papers 17583, National Bureau of Economic Research, Inc.
  4. Anton Korinek, 2011. "The New Economics of Prudential Capital Controls: A Research Agenda," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 59(3), pages 523-561, August.
  5. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
  6. Olivier Jeanne & Anton Korinek, 2010. "Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach," American Economic Review, American Economic Association, vol. 100(2), pages 403-407, May.
  7. Blanchard, Olivier Jean & Kiyotaki, Nobuhiro, 1987. "Monopolistic Competition and the Effects of Aggregate Demand," American Economic Review, American Economic Association, vol. 77(4), pages 647-666, September.
  8. Joseph E. Stiglitz, 1982. "The Inefficiency of the Stock Market Equilibrium," Review of Economic Studies, Oxford University Press, vol. 49(2), pages 241-261.
  9. Bruce C. Greenwald & Joseph E. Stiglitz, 1986. "Externalities in Economies with Imperfect Information and Incomplete Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 101(2), pages 229-264.
  10. Geanakoplos, J. & Magill, M. & Quinzii, M. & Dreze, J., 1990. "Generic inefficiency of stock market equilibrium when markets are incomplete," Journal of Mathematical Economics, Elsevier, vol. 19(1-2), pages 113-151.
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