Targeting financial stability: macroprudential or monetary policy?

David Aikman, Julia Giese, Sujit Kapadia and Michael McLeay in this ECB paper look at this question:

Monetary and macroprudential policies are set with reference to economic and financial cycles. This paper develops a simple macroeconomic model with the possibility of a financial crisis that describes how interest rates and macroprudential policy – as captured by the countercyclical capital buffer (CCyB) – interact in response to different shocks. It characterises situations in which the policy instruments move in the same, and in the opposite, direction. And it considers the appropriate design of policy under a range of potential shocks and challenges which policymakers may face.

First, the paper finds that there are minimal gains from monetary and macroprudential policy being set by a single policymaker compared with two distinct policymakers, one with a monetary policy objective and the other with a macroprudential policy objective.

Second, the paper shows that if monetary policy becomes constrained by the effective (zero) lower bound to interest rates, the trade-off faced by policy makers is worse because the CCyB must balance both objectives.  In particular, it should be activated later than otherwise, because its demand costs are larger without monetary policy to offset them.

Third, the paper explores a case in which there are leakages from tight macroprudential policy applied to banks into greater credit growth in the marketbased finance sector.The presence of market-based finance limits the effectiveness of the CCyB relative to monetary policy which affects all sectors equally and so it should be used less actively in the face of a credit boom.

In a final extension, the paper explores the risktaking channel of monetary policy. Tightening the CCyB is, by assumption, now less effective in constraining credit growth as low interest rates continue to induce high risktaking. But the CCyB remains a somewhat effective tool as it still improves resilience.

Hmm…

 

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