Optimal Macro-Prudential and Monetary Policy∗

This paper addresses two main questions. First, it examines the implications of financial frictions, embedded in a New Keynesian DSGE model with a banking sector, for the conduct of welfare-optimal monetary policy. Assuming only one monetary instrument, we analyse how financial frictions affect the gains from commitment and how different are the optimized simple rules with and without financial frictions, when monetary policy responds only to non-financial variables. Then we proceed to investigate whether there is a welfare benefit from monetary policy responding to financial variables, such as spreads, leverage or Tobin Q. Second, this paper studies the role of a macro-prudential instrument, a subsidy for net worth financed by a tax on loans, for improving welfare outcomes. Assuming both monetary and macroprudential instruments, we study the welfare gains from using the macro-prudential instrument and whether there are additional gains from commitment. Moreover, we examine if monetary policy and macro-prudential regulation should jointly target financial and non-financial variables, rules that may need to be implemented within one policy institution. JEL Classification: C11, C52, E12, E32.