Regulatory Capital Requirements, Inflation Targeting, and Equilibrium Determinacy

Xakousti Chrysanthopoulou (), Nikolaos Mylonidis () and Moise Sidiropoulos ()
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Xakousti Chrysanthopoulou: University of Ioannina
Nikolaos Mylonidis: University of Ioannina
Moise Sidiropoulos: University of Strasbourg, BETA

Open Economies Review, 2025, vol. 36, issue 1, No 3, 63-104

Abstract: Abstract This paper studies the stability properties of inflation-targeting interest rate rules in an economy with regulatory capital requirements. We derive the conditions for rational expectations equilibrium determinacy in a sticky-price model augmented with the cost channel of monetary policy transmission. We find that when tightening Basel II-type capital regulations, strict inflation targeting leads to significant expansions in regions of determinacy. This result is attributed to the supply side of credit markets, and especially to the procyclical nature of bank leverage and the restricted interest rate pass-through. However, when banks maintain capital ratios beyond the required thresholds, strict inflation targeting suffers from considerable shrinking regions of determinacy. Moreover, excessive bank capital holdings may give rise to self-fulfilling business cycles. The availability of countercyclical capital buffers, as proposed by Basel III, and/or a flexible inflation targeting regime offer an antidote to these problems.

Keywords: Equilibrium determinacy; Inflation targeting; Monetary policy; Regulatory capital requirements (search for similar items in EconPapers)
JEL-codes: G28 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s11079-024-09754-9

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