Should macroprudential policy be countercyclical?

Yoske Igarashi and Keqing Liu

Journal of Economic Dynamics and Control, 2024, vol. 158, issue C

Abstract: This paper investigates the influence of possible bank default and bank leverage constraints on monetary and macroprudential policy prescriptions. We build a New Keynesian model with banks that channel funds from households to firms. Banks face endogenous leverage constraints and are subject to costly default. We calibrate our model to the US economy and show that in the decentralized equilibrium, banks borrow more than the socially efficient level. A macroprudential policy that limits bank leverage reduces the risk of bank default and improves long-run welfare. In the short run, a “macroprudential-flavored” monetary policy can reduce financial propagation by affecting bank shadow values, while countercyclical capital regulation is effective for stabilizing bank leverage. While both policies are effective, our study shows that introducing countercyclicality to bank capital regulation achieves little welfare improvement if monetary policy is already used to mitigate financial acceleration. The jointly optimal policies suggest that policymakers should assign countercyclical macroprudential roles to monetary policy, and bank capital regulation should focus on the desired level of prudence.

Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:158:y:2024:i:c:s0165188923001719

DOI: 10.1016/j.jedc.2023.104765

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