Interaction between Monetary and Macroprudential Policy

Besides using Gerali et al. (2010) as a reference model, this chapter is also close with the work from Angelini, Neri and Panetta (2012). Angelini et al. (2012) study the policy coordination between monetary policy and macroprudential policy under cooperative and non-cooperative settings. The study incorporates macroprudential policy rules into the macroeconomic model developed by Gerali et al. (2010). Monetary authority uses a short- term interest rate as a policy instrument while macroprudential regulator uses capital requirements as the policy instrument. The loss function of monetary authority is calculated by the weighted sum of variation in inflation and output growth. Meanwhile, the loss function of macroprudential authority is calculated by the weighted sum of the variation in the loan-to-output ratio, capital requirement and output growth.

The cooperative setting of the two authorities is modelled to suppose that there is only one single institution that minimises the joint loss function of the two authorities. The financial constraints in the model are assumed to be always binding. The results show that under a cooperative setting, the welfare loss of depositors is greater under technology shocks than under financial shocks. However, the welfare loss of borrowers is relatively equal under both types of shocks. The study illustrates that cooperation between monetary and macroprudential authorities is not significant under normal circumstances triggered by technology shocks but is beneficial under financial shocks. Under financial shocks, the central bank deviates from its target and tends to place more focus on macroprudential policy issues.

Quint and Rabbanal (2013) study the optimal mix of monetary policy and macroprudential policy in the euro area. The authors utilise the Dynamic Stochastic General Equilibrium (DSGE) model with two types of financial intermediaries: domestic and international intermediaries. The model follows the financial accelerator model of Bernanke, Gilchrist and Gertler (1999). The monetary policy instrument used in the model is a short- term interest rate within two types of Taylor rules, namely the simple Taylor rule and the extended Taylor rule, which reacts to nominal credit growth and credit-to-GDP ratio. The macroprudential policy instrument used in the study is an exogenous variable that limits the loans given out to borrowers. This exogenous variable could be given in terms of increasing loan provisions, capital requirements, reserve requirements, or loan-to-value ratios. Instead of formulating the welfare loss function, the study defines the welfare function as the sum of the welfare of savers and borrowers, where each welfare function is derived by taking the

second order approximation to the utility function and subtracting it by the utility value at a steady state level. The results show that macroprudential and monetary policy coordination increases welfare under housing demand shocks and risk shocks. However, macroprudential policy reduces welfare under technology shocks and propagates the countercyclical behaviour of the lending-deposit spread.

Bailiu, Meh, and Zhang (2015) study the interaction between macroprudential and monetary policy under financial imperfection and financial shocks. The model is developed by the DSGE in a closed economy estimated based on Canadian data. The model is simulated under four scenarios: a standard Taylor rule regime, representing monetary policy focusing on price stability only; an augmented Taylor rule regime, representing monetary policy focusing on price stability and financial imbalance; a macroprudential policy regime with a standard Taylor rule, focusing on the interaction between macroprudential policy and monetary policy to maintain price stability; and a macroprudential policy with augmented Taylor rule regime, focusing on the interaction between macroprudential policy and monetary policy to maintain price stability and to prevent financial imbalances. It was found that monetary policy results in more welfare when its objective goes beyond price stability, either through fighting financial imbalances or interacting with macroprudential policy.

Kannan, Rabanal, and Scott (2012) study the coordination of monetary policy and macroprudential policy within the framework of a macroeconomic mode,l focusing on a housing price boom. The study was conducted in the spirit of Iacoviello (2005) and Iacoviello and Nerri (2010). The monetary and macroprudential policies were assumed to be mandated to a central bank. Within the study, the authors develop four combinations of policy rules: a simple Taylor rule (which serves as a baseline), an augmented Taylor rule, an augmented Taylor rule with macroprudential policy, and an optimised augmented Taylor rule with macroprudential policy. The four rules are then ranked based on traditional welfare criteria, minimising the variation of inflation and output gap. The monetary policy instrument in the model is policy rate, while the macroprudential policy instrument is the lagged nominal credit changes.

The results show that the the knowledge of the actual source of the housing price boom determines the efficacy of a macroprudential policy towards welfare. Under a productivity shock, macroprudential policy plays no role in the coordination, while it increases welfare when the economy is hit by a demand shocks. Furthermore, based on the welfare criterion comparison, the ranking of rules is influenced by the type of shocks that hit the economy. Under a housing shock or technology shock, the augmented Taylor rule is

preferred, while under a financial shock, the augmented Taylor rule with macroprudential policy is preferred.