Monetary and Macro-prudential Policies: An Integrated Analysis

This paper studies the interaction between monetary and macro-prudential policies in a simple model with both nominal and financial frictions. The nominal friction gives rise to a conventional monetary policy objective emphasized in the New Keynesian literature. 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 nominal rigidity perform in a model that also has the financial friction. We then study how two alternative macro-prudential regimes perform. The first is a macro-prudential adjusted monetary policy. The second is a two-part rule–a standard Taylor rule and a tax rule on the amount that the economy borrows. There are three main findings. First, contrary to standard New Keynesian wisdom, in an economy with the nominal rigidity and the financial 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 that there may be a trade off between macroeconomic and financial stability with a relatively aggressive 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-prudential augmented 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 monetary policy is accommodative. The same tax policy rule however can be welfare increasing when monetary policy is aggressive toward inflation as in this case it helps to address the possible trade off between macroeconomic and financial stability. JEL Classification: E52, F37, F41