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Optimal Monetary and Macroprudential Policies

Josef Schroth

Staff Working Papers from Bank of Canada

Abstract: This paper studies monetary policy in an economy where banks make risky loans to firms and provide liquidity services in the form of deposits to households. For given bank equity, market discipline implies that banks can take more deposits when assets are safer or more profitable. Banks respond to loan losses by making their balance sheets safer—i.e., they reduce risky lending sharply and accumulate more safe bonds. In contrast, a social planner would respond by making banks temporarily more profitable such that a riskier balance sheet can be maintained. A planner would temporarily reduce the expansiveness of monetary policy to avoid bonds becoming too liquid in support of the liquidity premium banks earn via deposits. Specifically, when bank equity is low, then optimal monetary policy stabilizes output by supporting bank lending rather than employment.

Keywords: Credit and credit aggregates; Financial stability; Financial system regulation and policies; Inflation targets; Monetary policy (search for similar items in EconPapers)
JEL-codes: E60 G28 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2021-05
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:21-21

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