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Monetary and Macro-Prudential Policies: An Integrated Analysis

Christopher Otrok (), Gianluca Benigno, Huigang Chen, Alessandro Rebucci () and Eric Young ()

No 1208, Working Papers from Department of Economics, University of Missouri

Abstract: This paper studies monetary and macro-prudential policies in a simple model with both a nominal rigidity and a financial friction that give rise to price and financial stability objectives. We find that lowering the degree of nominal rigidity or increasing the strength of the interest rate response to inflation is always welfare increasing in the model, despite a tradeoff between price and financial stability that we document. Even though crises become more severe as the economy moves toward price flexibility, the cost of the nominal rigidity is always higher than the cost of the financial friction in welfare terms in the model. We also find that macro-prudential policy implemented by augmenting traditional monetary policy with a reaction to debt is always welfare increasing despite making crises more severe. In contrast, implementing macro-prudential policy with a separate tax on debt is always welfare decreasing despite making crises relatively less severe. The key difference lies in the behaviour of the nominal exchange rate, that is more depreciated in the economy with the tax on debt and increases the initial debt burden.

Keywords: Financial Frictions; Financial Crises; Financial Stability; Macro-Prudential Policies; Nominal Rigidities; Monetary Policy. (search for similar items in EconPapers)
JEL-codes: E52 F37 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2012-07-24
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