Monetary and Macroprudential Policy in a Leveraged Economy

Abstract

We examine the optimal monetary policy in the presence of endogenous feedback loops between asset prices and economic activity. We reconsider this issue in the context of the financial accelerator model and when macroprudential policies can be pursued. Absent macroprudential policy, we first show that the optimal monetary policy leans considerably against movements in asset prices and risk premia. We show that the optimal policy can be closely approximated and implemented using a speed-limit rule that places a substantial weight on the growth of financial variables. An endogenous feedback loop is crucial for this result, and price stability is otherwise quasi-optimal. Similarly, introducing a simple macroprudential rule that links reserve requirements to credit growth dampens the endogenous feedback loop, leading the optimal monetary policy to focus on price stability.

Unpleasant Monetarist Arithmetic: Macroprudential Edition

“…16 Third, and because of policy is consistent with most of the literature, e.g. Alpanda and Zubairy (2017), Paul (2017), Svensson (2016b), Leduc and Natal (2016), IMF (2015), Kiley and Sim (2015) and Gali's (2014). For more see Appendix A.…”

“…These features encapsulate the 'intertwined cords' assumption (iv). They further imply that M&Ms are partial (but not perfect) substitutes in reducing cyclical swings; each still has a comparative advantage in stabilizing its 'own' shock (for more see Kohler, 2014, andLeduc andNatal, 2016). 12 Given this reduced-form 'correspondence' with Carrillo et al (2017), it is unsurprising that their key result regarding the Tinbergen rule applies in our model too.…”

“…Recent literature provides a growing number of avenues that can formalize excessive credit booms and asset bubbles, see e.g. Leduc and Natal (2016), Boz and Mendoza (2014), Brunnermeier and Sannikov (2014b), Klaus et al (2014) and Gali (2014).…”

Unpleasant Monetarist Arithmetic: Macroprudential Edition

“…15 For an insightful discussion of the problems of the efficient market hypothesis, see Barberis and Thaler (2003). Recent literature provides a growing number of avenues that can formalise excessive credit booms and asset bubbles; see, for example, Bianchi et al (2012), Boz and Mendoza (2014), Brunnermeier and Sannikov (2014b), Gal ı (2014), Adam et al (2017), and Leduc and Natal (2018). For some empirical evidence in the Australian housing market see Fry et al (2010) and Shi et al (2016).…”

Benchmarking Macroprudential Policies: An Initial Assessment

“…al. 2015, Leduc and Natal 2015, and also Bank of England 2009. Nevertheless, our concern is with an empirical evaluation of the characteristics of existing macroprudential regimes at the present time.…”