Ijhy
WP/09/257
Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy
Papa N’Diaye
© 2009 International Monetary Fund
WP/09/257
IMF Working Paper Asia and Pacific Department Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy Prepared by Papa N’Diaye Authorized for distribution by Nigel Chalk November 2009 Abstract This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.
This paper explores how prudential regulations can support monetary policy in reducing output fluctuations while maintaining financial stability. It uses a new framework that blends a standard model for monetary policy analysis with a contingent claims model of financial sector vulnerabilities. The results suggest that binding countercyclical prudential regulations can help reduce output fluctuations and lessen the risk of financial instability. More specifically, countercyclical rules such as countercyclical capital adequacy rules, can allow monetary authorities to achieve the same output and inflation objectives but with smaller adjustments in interest rates. The countercyclical rules can help stem swings in asset prices, lean against a financial accelerator process, and thereby help to lower risks of macroeconomic and financial instability. In economies with fixed exchange rates, where countercyclical monetary policy is not possible, prudential regulations can provide a useful mechanism for mitigating a run-up in asset prices and for promoting output stability. JEL Classification Numbers: E51, E58, E37, G13, G18. Keywords: Monetary policy, asset prices, macro prudentials, contingent claim analysis. Author’s E-Mail Address: pndiaye@imf.org
2
Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy
Papa N’Diaye
© 2009 International Monetary Fund
WP/09/257
IMF Working Paper Asia and Pacific Department Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy Prepared by Papa N’Diaye Authorized for distribution by Nigel Chalk November 2009 Abstract This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.
This paper explores how prudential regulations can support monetary policy in reducing output fluctuations while maintaining financial stability. It uses a new framework that blends a standard model for monetary policy analysis with a contingent claims model of financial sector vulnerabilities. The results suggest that binding countercyclical prudential regulations can help reduce output fluctuations and lessen the risk of financial instability. More specifically, countercyclical rules such as countercyclical capital adequacy rules, can allow monetary authorities to achieve the same output and inflation objectives but with smaller adjustments in interest rates. The countercyclical rules can help stem swings in asset prices, lean against a financial accelerator process, and thereby help to lower risks of macroeconomic and financial instability. In economies with fixed exchange rates, where countercyclical monetary policy is not possible, prudential regulations can provide a useful mechanism for mitigating a run-up in asset prices and for promoting output stability. JEL Classification Numbers: E51, E58, E37, G13, G18. Keywords: Monetary policy, asset prices, macro prudentials, contingent claim analysis. Author’s E-Mail Address: pndiaye@imf.org
2
References: Bernanke, B., 2002, “Asset-Price ‘Bubbles’ and Monetary Policy,” remarks before the of the National Association for Business Economics , New York Chapter, October. Bernanke, B., M. Gertler, and S. Gilchrist, 1999, “The Financial Accelerator in a Quantitative Business Cycle Framework,” in Handbook of Macroeconomics, ed. by J. Taylor and M. Woodford (Amsterdam: Elsevier). Blanchard, O., and J. Gali, 2006, “A New Keynesian Model with Unemployment,” draft, National Bureau of Economic Research. Berg, A., P. Karam, and D. Laxton, 2006, “Practical Model-Based Monetary Policy Analysis—A How-To Guide,” IMF Working Paper 06/81 (Washington: International Monetary Fund). Borio, C and M Drehmann (2009) “Assessing the risk of banking crises – revisited”, BIS Quarterly Review, March, pp. 29-46. Gray, Dale, and Samuel Malone, 2008, “Macrofinancial Risk Analysis,” (West Suxxex: Wiley Finance). Gray, D., R. C. Merton, and Z. Bodie, 2008, “A New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability,” Harvard Business School WP 09-015. Greenspan, Alan, 2004, “Risk and Uncertainty in Monetary Policy,” American Economic Association Papers and Proceedings, Vol. 94, No. 2, pp. 33–40. Hunt, B., P. Isard, and D. Laxton, 2003, “Inflation Targeting and the Role of the Exchange Rate,” (unpublished; Washington: International Monetary Fund). Hunt, B., and A. Orr, 1999, “Monetary Policy Under Uncertainty,” Reserve Bank of New Zealand Conference (Wellington: Reserve Bank of New Zealand). Karam, P, D. Gray, and P. N’Diaye, 2009, “Integrating Macro-Financial Sector Analysis,” forthcoming, IMF Working Paper (Washington: International Monetary Fund). Kiyotaki, N., and J. Moore, 1997, “Credit Cycles,” Journal of Political Economy, Vol. 105, pp. 211–48. Merton, R.C. , 1998, “Applications of Option-Pricing Theory: Twenty-Five Years Later,” Les Prix Nobel 1997, Stockholm: Nobel Foundation; reprinted in American Economic Review, Vol. 88 (June), pp. 323–49. Selody, J, and C. Wilkins, 2004, “Asset Prices and Monetary Policy: A Canadian Perspective On The Issues,” Bank of Canada Review, Vol. 2004 (Autumn), pp. 3–14.. Taylor, J, ed., 1999, Monetary Policy Rules (Chicago: University of Chicago Press).