In the decades prior to the crisis, macroeconomic management evolved to assign a strong role to monetary policy, with a primary focus on price stability. The framework of monetary policy was broadly converging toward one with an inflation target (explicit or implicit) and a short-term interest rate as a tool (Blanchard, Dell’Ariccia and Mauro 2010). While boom-bust cycles in asset prices and credit were observed prior to the recent crisis, these did not seriously challenge the prevailing paradigm. Meanwhile, in most economies, prudential policies were focused narrowly on the soundness of individual firms.
Price stability, however, did not ensure macroeconomic stability (Figure 1). This means that additional tools will be helpful in complementing monetary policy in countercyclical management. The use of financial regulation focused on macro-financial risks: macroprudential policies emerge as candidates.
The newly emerging paradigm is one in which both monetary policy and macroprudential policies are used for countercyclical management: monetary policy primarily aimed at price stability; and macroprudential policies primarily aimed at financial stability. But these policies interact with each other and thus each may enhance or diminish the effectiveness of the other (Figure 2).
In a recent paper (IMF 2012) we examine the conduct of both monetary and macroprudential policies in the presence of interactions. The paper first focuses on an ideal benchmark, in which both policies work perfectly in achieving their objectives, and then we address three additional questions:
- If macroprudential policies work imperfectly, what are the implications for monetary policy?
- If monetary policy is constrained, what is the role for macroprudential policies?
- If there are institutional and political economy constraints, how can macroprudential and monetary policies be adjusted?
Figure 1. Output-gap estimates, headline inflation, house price, and proportion of construction components
Source: World Economic Outlook and Haver Analytics.
Figure 2. Monetary and macroproduential policy interactions
Benchmark world, when policies work perfectly
When price rigidities are the only distortion, stabilising inflation is equivalent to maximising welfare (Woodford 2003). By keeping monetary policy focused on price stability, output stability is guaranteed and the best feasible outcome is obtained.
In the presence of financial market imperfections, individual behaviour is distorted, giving rise to excessive risk-taking ex ante – in the form of excessive leverage, large exposure to risky assets, and fragile liability compositions – and negative asset-price or exchange-rate externalities ex post. In short, boom-bust cycles are amplified (Bianchi 2011, Caballero and Krishnamurthy 2003, ibid. 2004, Lorenzoni 2008, Mendoza 2010, and Korinek 2010). Welfare maximisation then requires adding financial stability as an intermediate goal for policy, because financial instability signals distortions in the level and/or composition of output (Curdia and Woodford 2009; Carlstrom and Fuerst 2010) (see Figure 1).
While operationalising financial stability is not easy because of the large range of financial distortions and their changes over time, the task of preserving financial stability is nonetheless clear: mitigating financial distortions and the risks associated with them1.
Preserving financial stability
- Monetary policy alone cannot achieve financial stability because the causes of financial instability are not always related to the degree of liquidity in the system (which monetary policy can fix);
Mitigating the effects of financial distortions or pricking an asset-price bubble can require large changes in the policy rate (Bean et al. 2010) and when financial distortions are more acute in some sectors of the economy than in others, monetary policy is too blunt a tool.
- The use of macroprudential policies primarily for managing aggregate demand may in fact create additional distortions by imposing constraints on behaviour beyond those areas where financial distortions originate;
It is thus desirable, when both policies are available, to keep monetary policy primarily focused on price stability and macroprudential policies on financial stability.
Monetary policy, however, has side effects that can affect financial stability when it pursues its primary objective:
- By shaping ex-ante risk-taking incentives of individual agents, through leverage, short-term borrowing, or foreign-currency borrowing;
- Or by affecting ex-post the tightness of borrowing constraints and possibly exacerbating asset-price and exchange-rate externalities and leverage cycles;
Macroprudential policies also have side effects. By constraining borrowing and hence expenditure in one or more sectors of the economy, macroprudential policies affect overall output.
These side effects imply that the new paradigm needs to take into account how the conduct of both policies is affected in the presence of their interactions:
- If macroprudential policies have strong effects on output, more accommodative monetary policy can offset these effects as necessary;
- If changes in the monetary stance affect incentives to take too much risk, the relevant macroprudential policies would need to be tightened;
A number of papers surveyed by the IMF (2012) support this conclusion. In particular, these models suggest that the optimal calibration of the reaction of monetary policy to output and inflation does not change markedly when macroprudential policy is also used, even when different types of shocks are considered. In other words, the sole presence of side effects has no major implications for the conduct of both policies, however, when policies operate perfectly.
These conclusions rely on important simplifications, namely that the macroprudential instruments are perfectly targeted, fully offset the financial shock or distortion, and are immune to time-inconsistency issues arising in part for reasons of political economy. Constraints on one policy may increase the burden on the other and additional distortions and political-economy factors can give rise to coordination issues.
Imperfect macroprudential policies
There are a number of reasons why macroprudential policies may not operate perfectly. Financial stability concerns are hard to capture in practice making it difficult to determine when macroprudential policies need to be loosened, or tightened. Limited knowledge on their quantitative impact makes calibration difficult. Similarly, it may be the case that addressing one distortion improves other manifestations of financial instability, or the other way around. Moreover, institutional constraints may impede the optimal deployment of macroprudential instruments. For instance, macroprudential policies can require, among others, cooperation and coordination with microprudential supervisory agencies, which may be legally or institutionally difficult.
These imperfections may themselves lead to imperfectly targeted or excessively tight macroprudential policies, implying a binding constraint in the wrong place or at the wrong time with negative consequences on welfare (Caballero and Krishnamurthy 2004)2. Tighter regulations can also create stronger incentives for circumvention, with the risk of vulnerabilities building up outside of the regulatory perimeter and policymakers’ sight.
Weaknesses in the application of macroprudential policies make it more likely that monetary policy may need to respond to financial conditions. Indeed, in models where macroprudential policy is absent or time invariant, but in the presence of financial sector distortions, it is optimal for monetary policy to respond to financial conditions, in addition to the output gap and deviations of inflation from target (see Curdia and Woodford 2009, Carlstrom and Fuerst 2010). By extension, to reduce the effects of imperfectly targeted or less effective macroprudential policy, it can be desirable for monetary policy to respond to financial conditions and ‘lend a hand’ in achieving financial stability (e.g., by ‘leaning’ against the credit cycle).
Constraints on monetary policy
In small open economies with exchange-rate pegs, the effective monetary stance can give rise to excessively strong incentives for risk-taking. In such cases, macroprudential policies will need to address the adverse side effects of monetary policy on financial stability3. Nonetheless, where monetary arrangements are not adequate, there is more to gain from strengthening monetary policy’s effectiveness than from using macroprudential policies as imperfect substitutes.
Where monetary policy is constrained, the demands on macroprudential policy will be greater. Just as it is optimal for monetary policy to respond directly to financial conditions when macroprudential policies are absent and when financial distortions have an effect in the composition of output, it is optimal for macroprudential policy to respond to aggregate demand when monetary and fiscal policy are constrained.
Institutional and political-economy considerations
In the well-studied monetary-fiscal interactions, distortions introduced by fiscal policy (Dixit and Lambertini 2003) or time-inconsistency problems stemming from political factors (Barro and Gordon 1983) generate coordination issues. Similar problems can arise here. A microprudential regulator in charge of macroprudential policies may tighten regulation in a recession. Or problems may arise when macroprudential policies do not work perfectly, for reasons given earlier. In addition, different institutions can have different views of the economy and the financial system, which can lead to ineffective policy coordination.
To enhance coordination, the central bank can adopt a leading role in macroprudential policy. This has some key advantages. It can ensure that macroprudential policy draws on the central bank’s expertise in financial and macroeconomic analyses, that data and analyses prepared for each policy field are also available to the other, and facilitate analyses of the side effects of each policy. Furthermore, it can help shield the macroprudential policy function more from political influence than when it is assigned to a separate regulatory body. It also has risks though. A central bank formally responsible for both price and financial stability could be tempted to use inflation to repair private balance sheets following a financial shock, leading to a welfare loss (Ueda and Valencia 2012). With such time consistency as well as other conflicts, a dual mandate can be associated with lower credibility and create reputational risks. And it poses challenges for communication that could imply a loss in the transparency of monetary policy4.
When both monetary and macroprudential functions are housed within the central bank, coordination is improved but safeguards are needed to counter the risks from dual objectives. These should include separate decision-making structures for monetary and macroprudential policies. Separate accountability and communications structures are also advisable (such as separate reports to the legislature). It is often the case that these issues are best addressed in legislation, by establishing in law a central bank’s governance structure and clarifying the primary objectives of each policy function.
The crisis has accelerated the development of macroprudential policy, raising questions about how it interacts with monetary policy. Monetary policy can affect financial stability and macroprudential policies can affect output and inflation. However, in a world where each policy operates perfectly in attaining its objective, these side effects do not pose significant challenges to the conduct of both policies. With weaknesses in the application of macroprudential policies, monetary policy may still need to respond to the build-up of financial risk, by ‘leaning’ against the credit cycle, and, at times, be expansionary following negative financial shocks. Conversely, where monetary policy is constrained, there will be greater demands on macroprudential policy.
Institutionally, it can be advantageous to assign both policies to the same authority, namely the central bank. However, safeguards are then needed to counter the risks of dual objectives, and institutional frameworks should distinguish between the two policy functions, with separate decision-making, accountability and communication structures.
Disclaimer: The views expressed in this column are the authors' and not necessarily those of the institutions with which they are affiliated.
Barro, Robert J, and David B Gordon (1983), “A Positive Theory of Monetary Policy in a Natural Rate Model”, Journal of Political Economy, 91 (4), August, 589 610.
Bean, Charles, Matthias Paustian, Adrian Penalver, and Tim Taylor (2010), “Monetary Policy after the Fall”, Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole.
Bianchi, Javier (2010), “Credit Externalities: Macroeconomic Effects and Policy Implications”, The American Economic Review, 100 (2), 398-402.
Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro (2010), “Rethinking Macroeconomic Policy”, IMF Staff Discussion Note 10/03.
Caballero, Ricardo, and Arvind Krishnamurthy (2003), “Excessive Dollar Debt: Financial Development and Underinsurance”, Journal of Finance, 58(2), 867–94.
Caballero, Ricardo, and Arvind Krishnamurthy (2004), “Smoothing Sudden Stops,” Journal of Economic Theory, Vo. 119, No. 1, pp. 104–27.
Carlstrom, Charles, and Timothy Fuerst (2010), “Optimal Monetary Policy in a Model with Agency Costs”, Journal of Money, Credit and Banking, 42, 37–70.
Claessens, Stijn, Swati Ghosh, and Roxana Mihet (2012), “Macro-Prudential Policies to Mitigate Financial System Vulnerabilities”, IMF Working Paper, forthcoming.
Curdia, Vasco, and Michael Woodford (2009), “Credit Frictions and Optimal Monetary Policy”, Bank for International Settlements Working Paper No. 278.
De Nicolò, Gianni, Giovanni Favara, and Lev Ratnovski (2012), “Externalities and Macroprudential Policy”, IMF Staff Discussion Note 12/05.
Dixit, Avinash, and Luisa Lambertini (2003), “Interactions of Commitment and Discretion in Monetary and Fiscal Policies”, The American Economic Review, 93(5), 1522 542.
Federico, Pablo, Carlos Vegh, and Guillermo Vuletin (2012), “Reserve requirement policy over the business cycle”, University of Maryland, mimeo.
Giavazzi, Francesco, and Frederic S Mishkin (2006), “An Evaluation of Swedish Monetary Policy Between 1995 and 2005”, Stockholm, Sveriges Riksdag.
IMF (2012), “The Interaction of Monetary and Macroprudential Policies”, IMF Policy Paper, .
Korinek, Anton (2010), “Regulating Capital Flows to Emerging Markets: An Externality View”, University of Maryland, mimeo.
Lorenzoni, Guido (2008), “Inefficient Credit Booms”, Review of Economic Studies, 75(3), 809–33.
Mendoza, Enrique (2010), “Sudden Stops, Financial Crises, and Leverage”, The American Economic Review, 100(5), 1941–66.
Tovar, Camilo E, Mercedes Garcia-Escribano, and Mercedes Vera Martin (2012), “Credit Growth and the Effectiveness of Reserves Requirements and Other Macroprudential Instruments in Latin America”, IMF Working Paper No. 12/142.
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Woodford, Michael (2003), Interest and Prices, Princeton University Press, New Jersey.
1 De Nicolò et al (2012) present a taxonomy of macroprudential tools.
2 In an analysis of the evolution of banking-system vulnerabilities in relation to the use of macroprudential policies, Claessens et al. (2012) find that some macroprudential policies can impose constraints that lead banks to adjust perversely in times of financial downturns.
3 For instance, in the case of a currency union, loan-to-value ratios and capital buffers need to respond to asset bubbles and credit booms that may arise at the national level, rather than at the level of the region. This is independent of whether the calibration powers sit at the national level or at the centre.
4 Giavazzi and Mishkin (2006) conducted interviews with participants from different sectors of Swedish society and found that statements on house prices by the Riksbank confused the public. Also, in a number of small open economies, reserve requirements are used with both monetary policy and macroprudential policies objectives (Federico et al. 2012; and Tovar et al. 2012), raising communication challenges.