Optimal Monetary and Prudential Policies

Fabrice Collard, Harris Dellas (), Behzad Diba and Olivier Loisel

No 2012-34, Working Papers from Center for Research in Economics and Statistics

Abstract: The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability and has raised the question of whether and how to combine the corresponding main policy instruments (interest rate and bank-capital requirements). This paper offers a characterization of the jointly optimal setting of monetary and prudential policies and discusses its implications for the business cycle. The source of financial fragility is the socially excessive risk-taking by banks due to limited liability and deposit insurance. We characterize the conditions under which locally optimal (Ramsey) policy dedicates the prudential instrument to preventing inefficient risk-taking by banks; and the monetary instrument to dealing with the business cycle, with the two instruments co-varying negatively. Our analysis thus identifies circumstances that can validate the prevailing view among central bankers that standard interest-rate policy cannot serve as the first line of defense against financial instability. In addition, we also provide conditions under which the two instruments might optimally co-move positively and countercyclically.

Keywords: Prudential policy; Capital requirements; Monetary policy; Ramsey-optimal policies (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 (search for similar items in EconPapers)
Pages: 35
Date: 2012-12
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cta, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (35)

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Related works:
Journal Article: Optimal Monetary and Prudential Policies (2017)
Working Paper: Optimal Monetary and Prudential Policies (2012)
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