Regulatory capital requirements, inflation targeting, and equilibrium determinacy

Chrysanthopoulou Xakousti, Nikolaos Mylonidis and Sidiropoulos Moise
Authors registered in the RePEc Author Service: Yamina Tadjeddine

Working Papers of BETA from Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg

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: E44 E52 E58 G28 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:ulp:sbbeta:2024-05

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