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Monetary and Macro-Prudential Policies: An Integrated Analysis

This paper studies monetary and macro-prudential policies in a simple model with both a nominal rigidity and a financial friction that give rise to price and financial stability objectives. We find that lowering the degree of nominal rigidity or increasing the strength of the interest rate response to inflation is always welfare increasing in the model, despite a tradeoff between price and financial stability that we document. Even though crises become more severe as the economy moves toward price flexibility, the cost of the nominal rigidity is always higher than the cost of the financial friction in welfare terms in the model. We also find that macro-prudential policy implemented by augmenting traditional monetary policy with a reaction to debt is always welfare increasing despite making crises more severe. In contrast, implementing macro-prudential policy with a separate tax on debt is always welfare decreasing despite making crises relatively less severe. The key difference lies in the behaviour of the nominal exchange rate, that is more depreciated in the economy with the tax on debt and increases the initial debt burden.

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Paper provided by Department of Economics, University of Missouri in its series Working Papers with number 1208.

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Length: 39 pgs.
Date of creation: 24 Jul 2012
Date of revision:
Handle: RePEc:umc:wpaper:1208
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  1. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2010. "Financial Crises and Macro-Prudential Policies," CEP Discussion Papers dp1032, Centre for Economic Performance, LSE.
  2. Fernández, Andrés & Gulan, Adam, 2012. "Interest rates and business cycles in emerging economies: The role of financial frictions," Research Discussion Papers 23/2012, Bank of Finland.
  3. Dominic Quint & Pau Rabanal, 2013. "Monetary and Macroprudential Policy in an Estimated DSGE Model of the Euro Area," IMF Working Papers 13/209, International Monetary Fund.
  4. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2010. "Revisiting Overborrowing and Its Policy Implications," IDB Publications (Working Papers) 6855, Inter-American Development Bank.
  5. Javier Bianchi, 2010. "Overborrowing and Systemic Externalities in the Business Cycle," 2010 Meeting Papers 96, Society for Economic Dynamics.
  6. Ambrogio Cesa-Bianchi & Alessandro Rebucci, 2013. "Does Easing Monetary Policy Increase Financial Instability?," IDB Publications (Working Papers) 79499, Inter-American Development Bank.
  7. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  8. Huigang Chen & Eric Young & Christopher Otrok & Alessandro Rebucci & Gianluca Benigno, 2013. "Optimal Policy for Macro-Financial Stability," 2013 Meeting Papers 636, Society for Economic Dynamics.
  9. Fornaro, Luca, 2015. "Financial crises and exchange rate policy," Journal of International Economics, Elsevier, vol. 95(2), pages 202-215.
  10. D. Filiz Unsal, 2011. "Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses," IMF Working Papers 11/189, International Monetary Fund.
  11. Bruce Greenwald & Joseph E. Stiglitz, 1993. "New and Old Keynesians," Journal of Economic Perspectives, American Economic Association, vol. 7(1), pages 23-44, Winter.
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