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Optimal Monetary and Prudential Policies †

Optimal Monetary and Prudential Policies † Abstract The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability, raising questions about how to combine monetary and prudential policies. This paper characterizes the jointly optimal monetary and prudential policies, setting the interest rate and bank-capital requirements. The source of financial fragility is the socially excessive risk taking by banks due to limited liability and deposit insurance. We provide conditions under which locally (Ramsey) optimal 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 covarying either negatively, or positively and countercyclically. (JEL E32, E43, E44, E52, G01, G21, G28 ) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Journal: Macroeconomics American Economic Association

Optimal Monetary and Prudential Policies †

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Publisher
American Economic Association
Copyright
Copyright © 2017 by the American Economic Association
Subject
Articles
ISSN
1945-7715
eISSN
1945-7715
DOI
10.1257/mac.20140139
Publisher site
See Article on Publisher Site

Abstract

Abstract The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability, raising questions about how to combine monetary and prudential policies. This paper characterizes the jointly optimal monetary and prudential policies, setting the interest rate and bank-capital requirements. The source of financial fragility is the socially excessive risk taking by banks due to limited liability and deposit insurance. We provide conditions under which locally (Ramsey) optimal 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 covarying either negatively, or positively and countercyclically. (JEL E32, E43, E44, E52, G01, G21, G28 )

Journal

American Economic Journal: Macroeconomics – American Economic Association

Published: Jan 1, 2017

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