A Theory of Macroprudential Policies in the Presence of Nominal Rigidities

Abstract

We propose a theory of monetary policy and macroprudential interventions in financial markets. We focus on economies with nominal rigidities in goods and labor markets and subject to constraints on monetary policy, such as the zero lower bound or fixed exchange rates. We identify an aggregate demand externality that can be corrected by macroprudential interventions in financial markets. Ex post, the distribution of wealth across agents affects aggregate demand and output. Ex ante, however, these effects are not internalized in private financial decisions. We provide a simple formula for the required financial interventions that depends on a small number of measurable sufficient statistics. We also characterize optimal monetary policy. We extend our framework to incorporate pecuniary externalities, providing a unified approach to both externalities. Finally, we provide a number of applications which illustrate the relevance of our theory.

Household Debt and Business Cycles Worldwide

“…For example, the relation between household debt and the business cycle is spuriously generated by expected income shocks in the credit demand hypothesis, leaving no special role for regulation. However, under the credit supply hypothesis, households may over-extend themselves when borrowing during a credit supply boom, necessitating the need for macro-prudential regulation.We present a number of results that reject the credit demand hypothesis and support the credit 1 See, e.g., Mian and Sufi (2014) and IMF (2012) for empirical evidence and Eggertsson and Krugman (2012), Guerrieri and Lorenzoni (2015), Farhi and Werning (2015), Korinek and Simsek (2016), Schmitt-Grohé and Uribe (2016), and Martin and Philippon (2014) for theoretical analysis.1 supply hypothesis. We show that an increase in the household debt to GDP ratio over a three year period 2 in a given country predicts subsequently lower output growth.…”

Optimal Bank Regulation in the Presence of Credit and Run Risk

“…Our analysis is related to the emerging literature exploring optimal macroprudential regulation to address various inefficiencies, such as aggregate demand externalities in the presence of nominal rigidities (Farhi and Werning, 2016), pecuniary externalities operating through collateral constraints (Bianchi and Mendoza, forthcoming) or fire-sales externalities (Stein, 2012). However, our focus is different as we are interested in identifying externalities that pertain to banks choices associated with endogenous credit risk and run risk.…”

“…19 Farhi and Werning, 2016, and Bianchi and Mendoza, forthcoming, consider such taxes to implement the constrained efficient allocations. Note that the taxes can also take negative values, in which case they are interpreted as subsidies.…”

Liquidity policies and systemic risk

“…While the literature on macroprudential policies in dynamic general equilibrium models is recent, it is growing rapidly (see Goodhart, Kashyap, Tsomocos, and Vardoulakis [2012], Angelini, Neri, and Panetta [2011], Angeloni and Faia [2013], Korinek [2011], Bianchi and Mendoza [2011], Nuño and Thomas [2012], and Farhi and Werning [2013]). The distinguishing feature of the current paper is to focus on the LCR, while other papers primarily focus on capital requirements and monetary policy.…”