Prudential Monetary Policy

Alp ÅžimÅŸek and Ricardo Caballero ()

No 13832, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Should monetary policymakers raise interest rates during a boom to rein in financial excesses? We theoretically investigate this question using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, there are conditions under which small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors' balance sheets. The policy is most effective when the recession is more likely and leverage limits are neither too tight nor too slack. With shadow banks, whether PMP "gets in all the cracks" or not depends on the constraints faced by shadow banks.

Keywords: Speculation; Leverage; Aggregate demand; Business cycle; Effective lower bound; Monetary policy; Regulation; Macroprudential policies; Leaning against the wind; Shadow banks (search for similar items in EconPapers)
JEL-codes: E00 E12 E21 E22 E30 E40 G00 G01 G11 (search for similar items in EconPapers)
Date: 2019-06
New Economics Papers: this item is included in nep-ban, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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