Monetary and Macro-Prudential Policies: An Integrated Analysis

This paper studies the interaction between monetary and macro-prudentialpolicies in a simple model with both nominal and financial frictions. The nominal frictiongives rise to a conventional monetary policy objective emphasized in the New Keynesianliterature. The financial friction, in the form of an occasionally binding collateral constraint,gives rise to a financial stability objective. We study how rules developed for the nominalrigidity perform in a model that also has the financial friction. We then study how twoalternative macro-prudential regimes perform. The first is a macroprudential adjustedmonetary policy. The second is a two-part rule–a standard Taylor rule and a tax ruleon the amount that the economy borrows. There are three main findings. First, contraryto standard New Keynesian wisdom, in an economy with the nominal rigidity and thefinancial friction, a relatively accommodative monetary policy may be welfare improving,suggesting a role for positive inflation in this environment. By the same token, we find thatthere may be a trade off between macroeconomic and financial stability with a relativelyaggressive monetary policy. Second, macro-prudential policy is most effective in our model(from a welfare ranking point of view) when it is designed in terms of macro-prudentialaugmented interest rate rules rather than through an independent tax rule on debt. Third,independent macro-prudential tax rules on debt can be welfare reducing when monetarypolicy is accommodative. The same tax policy rule however can be welfare increasing whenmonetary policy is aggressive toward inflation as in this case it helps to address the possibletrade off between macroeconomic and financial stability.

Keywords:

Financial Frictions , Financial Crises , Financial Stability , Macro-Prudential Policies , Nominal Rigidities , Monetary Policy