Monetary and Macro-Prudential Policies

Jorge Roldos IMF-CEMLA Course

Central Bank of Brazil, Brasilia October 2013

This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF Institute courses. Any reuse requires the permission of the IMF Institute.

“There is a danger that the macroeconomic models now in use in central banks…have been

constructed in the past as part of the war against inflation. The central banks are prepared to fight

the last war. But are they prepared to fight the new one against financial upheavals and

recession? The macroeconomic models they have today certainly do not provide them with the

right tools to be successful.” Paul de Grauwe, 2008

Contents

• Monetary Policy in Inflation Targeting Regimes – Case Study 1: Inflation Targeting and Financial Instability

• Monetary Models and Financial Intermediation

• Monetary and Macro-Prudential Policies – Monetary versus Macro-Prudential Rules – Assessing the Macro Impact of Basel III

Monetary Policy—J.Roldos 4

I. Monetary Policy and Inflation Targeting

• Central banks have three main objectives:

Price Stability

Output/ Employment

Stability

Financial Stability

I. Monetary Policy and Inflation Targeting

• Financial Stability has always been an objective for central banks – Lender of last resort (LOLR) function

• Main reason for their creation in many cases • After WWII, output and price stability became

the main objectives • In the 1990’s, “monetary dominance”

overtakes “fiscal dominance” in macro policies

Convergence in Macroeconomics

• Since the mid-1980’s we saw “Great Moderation” • A new macroeconomic “synthesis” emerged

– Macro analysis should use models with consistent intertemporal general equilibrium foundation (DSGE)

– Econometrically validated/calibrated – Endogenous expectations – Monetary policy should use interest rate to manage

aggregate demand

• New Keynesian model used by many central banks

The New Keynesian DSGE Model

• Aggregate demand, IS equation

• Expectations-augmented Phillips curve

• Policy (Taylor) rule

* *1 1[ ], where

is the output gapt t t t t t t t t tx E x r E r x y yπ+ += − − − = −

1 , where is inflationt t t t tE xπ β π κ π+= +

1 (1 )[ ], where is the interest ratet t t x t tr r x rπα α φ π φ−= + − +

The New Keynesian DSGE Model

• It is basically the IS-LM model with a Monetary Policy (MP) rule instead of LM (MM equilibrium)

• Macroeconomic equilibrium shown in next charts

(for given inflation expectations) • This three-equation NK model (Clarida-Gertler-

Gali) became the backbone of central banks’ inflation targeting (IT) regimes

The NK-DSGE is an IS-MP Model

Case Study 1: Inflation Targeting May Lead to Financial Instability

• Based on Christiano et al. (2007) • There is empirical evidence that episodes of

low goods price inflation are associated with high asset price inflation (stock price booms)

• Boom may reflect inefficiently loose monetary policy in an IT regime, when optimism about the future requires high real interest rates

• Problem of misusing the NK model

Periods of low inflation coincide with stock price and credit booms (U.S. 1810-1910)

Periods of low inflation coincide with stock price and credit booms (U.S. 1920-2010)

Summary Statistical Evidence

Case Study 1: Inflation Targeting May Lead to Financial Instability

• Boom-bust can be rationalized with NK model • Problem is that model is a “gap” model: all

variables as deviations from “steady state” • And steady-state is not constant, should

reflect the evolution of “natural” output, rates • Moreover, “news” or signals of better future

times could be an important driver of natural GDP, interest rates

The “missing” part of the 3-equation NK-model

• Natural or equilibrium output responds to productivity (“supply”) and leisure/labor (“demand”) shocks:

• The “news shock” is signal of future productivity

*

* * *1 1

0 1 11 1 1

1 , where is the productivity shock

( ) ( ), and evolves as:

; ; is "news shock"

t t t t

t t t t t t t t

t t t t t t t

y a a

r E y y E a a aa a u u

τϕ

ρ ξ ξ ξ+ +

− − −

= −

= − = −

= + = +

The “missing” part of the 3-equation NK-model

• Replacing evolution of technology into equilibrium interest rate:

• News of future technology improvement

requires higher current real interest rate

* 1

arg

( 1)t t tl esmall

r aρ ξ= − +

The “missing” part of the 3-equation NK-model

• But in the NK model higher future productivity means lower future marginal costs and inflation

• …and Taylor rule leads central bank to lower current nominal interest rate, inflating asset prices and creating a boom

(Taylor Rule)e et j t j t tmc rπ π+ +↓ ⇒ ↓ ⇒ ↓ ⇒ ↓

Case Study 1: Inflation Targeting May Lead to Financial Instability

• Bottom line: ignoring the underlying structural economy, and/or relevant shocks, could lead to mistakes in model use

• CIMR (2007) show that including a response to credit growth in the monetary policy rule improves welfare by avoiding boom-bust

• Why? : Credit growth responds to signal of higher future productivity, push rates higher

• Go back to themes of L-3, credit boom-bust

II. Monetary Policy Models and Financial Intermediation (FI)

• Early attempts to add FI to macro models: – Two interest rates – Rationale for FI – IS curve flatter (FA) – Shocks to credit supply

important for business cycles (shifts to IS curve)

A Disruption to Credit Supply

II. Monetary Policy Models and Financial Intermediation

• Main challenge to NK DSGE (or any) model is that FI requires two types of agents: borrower (impatient) and lender (patient)

• Another challenge is the behavior of the FI, and the resource cost for the economy

• And a final one is keeping track of the dynamics of borrowing (credit)

• Some classes of models that have made progress on these are reviewed in what follows

Curdia-Woodford (2009)

• Simple NK model with two additions 1. Heterogeneous households (borrower&lender) 2. Costly FI: resource cost and NPL

• Two factors affect the three equations:

1' '

, where is mg utility gap

( ) ( ) ( ), spread = mg cost of lending,

where ( ) is resource cost of lending and ( ) are NPLs

b st t t t t t tb s

t t t t t t

t t

s Er r s b b b

b b

λ λ δ

χ

χ

+− = Ω = + Ω Ω

− = = Ξ +

Ξ

Curdia-Woodford (2009)

• A fourth equation would have to be added:

• The three-equation model suffices only in special case where credit spread evolves exogenously and FI uses no resources (spread is just a mark-up)

1 1

cost of borrow

[1 ] (1 ) / ( )

(1 ) (1 ) , is FI balance sheet

st s t b t t t t b t t

b st t t t

b s b r b other

r b r d

δ α α π α− −= + + Ξ + − Ξ +

+ = +

Curdia-Woodford (2009)

• Even under such strict conditions, response to financial shock is equivalent to simultaneous shocks to: – Natural interest rate – “Cost-push” inflation – Monetary policy shock

• Result: Monetary Policy Rule that incorporates credit spread is better (more on this below), but weight depends on persistence of the financial shock

Christiano, Motto and Rostagno (2009)

• Model combines NK DSGE with capital accumulation, and financial accelerator (FA)

• Savings done by household, and risk neutral entrepreneur borrows to invest

• Need to add three new equations: 1. Optimal lending contract (menu) 2. Bank’s zero profit condition 3. Law of motion for entrepreneur net worth

Christiano, Motto and Rostagno (2009)

• Optimal contract where marginal revenue equals marginal cost of internal funds times external finance premium (EFP):

• Individual, idioscincratic shocks averaged out

11 1 1

, 1 1 1, 1

( ) , where ( ) is the EFP and[ (1 ) ]

is the return on capital

kt t t t t

i t t tki t

t

R Q K R QMPK Q

RQ

αα ρ ω ρ ωω δ

−+ + +

+ + ++

=+ −

=

Christiano, Motto and Rostagno (2009)

• Bank monitors borrower at default such that expected return equals cost of funds:

• Combining both expressions we get credit spread as a function of leverage:

1

expected proj. success

[ ( ) ( )] , where is monitoring costkt t t t tG R Q K R Bαω µ ω µ−Γ − =

1 1

1 1

[ ( )]kt t t

t t

R Q KS S LR N

ω+ +

+ +

= =

Christiano, Motto and Rostagno (2009)

• The evolution of entrepreneur net worth is:

• Entrepreneur’s net worth grows with leverage • Incentive to max leverage, mitigated by

increasing spread

1 1

11

Asset Returns-Debt Payout

( )

kt t t t t t

k t tt t t t t

t

N R Q K R B

Q KN R R R NN

+ −

−+

= − =

= − +

Christiano, Motto and Rostagno (2009) • Log-linearizing the two equations we get:

• The financial shock could also be an increase in the volatility of the firm’s profitability – A (tail) “risk” shock, on real sector – This type of shock sacounts for a large share of

business cycles in US and EU

1 1 1 1

( ) , where is shock to FI

( 1)( ) ,

where is shock to net worth

fi fit t t t t t

k nwt t t t t t t

nwt

s q k nn Lr L s r n

χ ε ε

π θ ε

ε− − − −

= + − +

= − − + − + +

Christiano, Motto and Rostagno (2009)

• First shock to entrepreneurial risk leads to: – Increase in spreads from 220 to 240 bps – Reduction in D/N from 0.92 to 0.8, 13% fall in loans

• Second shock, Δ in monitoring/bankruptcy cost: – Spread or EFP falls 64 bps (demand dominates) – Similar reduction in D/N or lending

• Monetary Policy tightening of 25 percent: – Spread rises by 34 bps – Lending falls 10 percent

Christiano, Motto and Rostagno (2009)

• Model with micro-founded FI shows how moves in spread may be small compared to those in lending (if dem&supply move same direction) – Models with spread only (or without explicit

contract for lending could be misleading) • Again, adding credit growth to Monetary Policy

rule improves welfare • One draw back of CMR: intermediary has no

capital; no bank failure or runs

Gilchrist and Zakrjsek (2011)

• Similar NK with FA, but shock to FI (not real project)

• An Δσ increases cost of FI for given leverage • Model matches the recent U.S. crisis, and

spread-augmented MP rule stabilizes GDP (with a bit of Δ inflation)

1

1

exp( ) , and the shock to FI follows:

(1 )

t tt t

t

t t t

Q KSN

χ

σ

σ ρ σ ρσ ε

+

−

=

= − + +

Gilchrist and Zakrjsek (2011)

Gilchrist and Zakrjsek (2011)

Gilchrist and Zakrjsek (2011)

II. Monetary Policy Models and Financial Intermediation (FI)—cont.

• Taking stock: NK DSGE + FA provides a good degree of amplification

• Dynamics of non-financial sector balance sheet and leverage micro-founded; spreads are counter-cyclical, good data fit

• But no meaningful FI, same with collateral constraints framework (see next table)

• Next class of models explicitly introduce a costly banking sector

Source: IMF/WP/

Gerali et al. (2010)

• A NK DSGE model with an explicit banking sector and collateral constraints

• Emphasis on supply-side of credit markets • Entrepreneurs and impatient households (HHs)

borrow, patient HHs lend deposits to banks • Banks are monopolistically competitive, setting

sticky loan and deposit rates; bank capital • One wholesale branch, two retail branches

Gerali et al. (2010) • Motivation: Interest rate spreads affected by

degree of competition and bank capital costs

Gerali et al. (2010)

• Entrepreneurs and impatient HHs borrow subject to collateral (LTV) constraints:

• Banks’ lending and deposit rates are set taking into account future values of the policy rate

1 1( ) [ ( ) ], where is the LTVb kt t t t t t t tR b i m E q k i mπ+ +≤

; lending, policy and deposit rates5.3>3.6>2.4 (percent)

b dt t tR R R> >

Gerali et al. (2010)

• Bank capital is accumulated out of retained earnings

• Banks max profits, and is costly to adjust

banks’ capital ratio (inverse to leverage L)

1(1 ) ; where are retained earningsb b b b bt t t t tK K j jπ δ −= − +

2

max ; is targeted CAR2

bb d b b btt t t t t

t

KR B R D KB

κ υ υ − − −

Gerali et al. (2010)

• Wholesale bank lending rates then depend on:

• Bank spread depends on bank leverage in

contrast to CMR (on firm’s leverage)

2

,b b

b d bt tt t

t t

K KR RB B

κ υ = − −

2b bw b d bt tt t t

t t

K KS R RB B

κ υ

= − = − −

Gerali et al. (2010)

• Macroeconomic shocks affect banks profits and capital, with feedback to the real economy

• Banks affect monetary transmission, attenuating effects on real economy (sticky interest rates)

• Banks also are subject to financial shocks (spreads, collateral and capital) that affect the economy

• Financial shocks explain large share of GDP fluctuations in 2004-2009 (next)

Gerali et al. (2010)

• Model suited to study effects of bank capital loss (crisis) as well as recapitalization efforts

• After capital loss, banks attempt to rebuild balance sheet: cut lending and increase spread

• Firms reduce investment, but increase capacity utilization and labor demand

• Inflation lead central bank to tighten marginally • “Stress” scenario with added ΔCAR (regulation)

Gerali et al.: Loss of Bank Capital

Gerali et al.: Loss of Bank Capital

III. Monetary and Macro-Prudential Policies

• The models sketched before allow for a number of applications

• In particular, analysis of monetary and macro-prudential policies

• Next, three applications – Monetary versus Macro-Prudential Rules – Impact of Basel III on GDP – Counter-cyclical capital adequacy ratios

Monetary versus Macro-Prudential Rules

• Based on Kannan, Rabanal and Scott (2009) • Key question: should central bank willing to

mitigate boom-bust cycles move policy rate in response to credit or asset prices/spreads?

• Answer is YES, but for purely financial shock the macro-prudential instrument has comparative advantage over MP rate

• Discretion needed since is hard to know the source of shocks

Kannan, Rabanal and Scott (2009)

• Model has non-durable and durable good (housing), only real asset

• Patient (lender) and impatient (borrower) HHs • FI set lending rate as function of LTV, s.t.

financial shock and macro-prudential instrument:

( / ) ; where (.) 0, (.) 0;, , are financial shock and macroprudential instrument

b b ht t t t t t t

t t

R R F B Q K F Fν τν τ

′ ′′= > >

Kannan, Rabanal and Scott (2009)

• Compare four policy regimes: – Taylor Rule – Augmented Taylor Rule (with credit growth) – Augmented Taylor Rule + Macro-prudential – Optimization [Augm.TR + Macro-prudential]

• The augmented TR and macro-prudential are:

1 1 1 1

1

(1 )[ ], augm. TR

( ), macroprudential instrumentt R t R t y t b t

t t

R R x B

Bπγ γ γ π γ γ

τ τ− − − −

−

= + − + +

=

Effect of a Financial Shock

Effect of a Productivity Shock

Kannan, Rabanal and Scott (2009)

• Bottom line: “comparative advantage” dictates that macro-prudential (M Policy) instrument should be used against financial (technology) shock

• Critical to be able to isolate shocks • The higher the incidence of financial shocks in an

economy, the more important the relative use of the macro-prudential instrument (LTV, RR)

Case Study 2: Shocks to World Interest Rates and Capital Flows

• In the aftermath of Lehman Bros. collapse, most countries cut interest rates sharply

• Same in major EM countries, but some of them cut Reserve Requirements even more (and earlier); especially Brazil and Peru (chart)

• What is the best response to this shock (and associated fluctuations in capital flows)?

• What if rates go back up (Fed “normalization”)?

MP Rate and Reserve Requirements

Shock to the World Interest Rate

Case Study 2: Shocks to Global Interest Rates and Capital Flows

• In Christiano et al, future (positive) productivity shocks increase the “natural” rate of interest

• But their was closed-economy model: for shock to global rates we want an open-economy model

• A few available, focus on other shocks or on response with capital controls

• An exception is Medina and Roldos (forthcoming IMF/WP), next

Overview of the Model

• Small open economy • Two differentiated tradable goods: Home and

Foreign • Nominal friction: price rigidity a-la-Calvo (1983) • Financial friction: financial accelerator plus a fire-

sales amplification mechanism – Solvency: loans’ default (Bernanke, Gertler and Gilchrist,

BGG, 1999) – Liquidity: real and financial resources are needed to

liquidate distressed assets (extension of Choi-Cook, 2012)

Labor Market

Firms

Capital Producers

Entrepreneurs

Households Liquidity Intermediaries

Lending Intermediaries

DR IBR

lRKR

K l IB DR R R R> > >

Figure 2—Timing of events

Period t Period t+1

Entrepreneur sell undepreciated to capital producers, repays loan to lend-intermediary

Capital producers buy new, undepreciated and restructured capital

Using net worth and loans Entrepreneur buys new eop capital from capital goods producers

After realization of shock Entrepreneur supplies capital services

1tK +

tB 1tω +

Production and Consumption

Lend-intermediary sells defaulted capital to liquid-intermediary; lends to finance next period capital

1(1 ) tKδ +−

Liquid-intermediary takes deposits, lends to interbank market and CB; Provides liquidity services

Financial Intermediaries and Spreads

• The two “financial intermediaries” summarize the main functions of a financial system: – Provision of credit services – Provision of liquidity services

• Both functions contribute to a “wedge” between deposit and lending rates: – Endogenous spreads will interact with monetary

policy rate and macro-prudential instrument

Credit Intermediary (1)

• Provides loans to entrepreneurs under a “BGG” contract that solves the agency problem

• The average return to capital for the entrepreneurs is capital is:

1 11 1

(1 ) ; where is the rental rate

and the price of capital

δ+ ++ +

+ −=K t t

t tt

t

VMPK QR VMPKQ

Q

Credit Intermediary (2)

• Threshold condition for lending rate:

• Zero profit condition for credit intermediary:

1 1 1 1 1, where is loan rate and is the loan

ϖ+ + + + +=k l lt t t t t t t

t

R K Q R B RB

( )

1

1 1 1 1 1 10Cost of FundsRevenue if loan repaid Revenue if default

1

[1 ( )] (1 )Φ( ; ) ,

where ( ) is the probability of default and

tl IBt t t t t t t t

t

R VMPKB FS k d R Bϖ

ωϖ δ ω ω σ

ϖ

+

+ + + + + +

+

−Φ + + − =

Φ

∫

1 is the fire-sale price of the defaulted capitaltFS +

Credit Intermediary (3) • Define:

• Then, zero profit condition for credit intermediary is:

• In contrast to BGG, cost of default is endogenous (and countercyclical); in recession: – Prob (Default) increases – Recovery rates fall (cost of default increases)

1 1 1 1 1 10Cost of FundsRevenue if loan repaid Revenue if default

[1 ( )] )Φ( ; ) 1 , (ϖ

ωϖ µ ω ω σ+ + + + + +−−Φ + =∫

l k IBt t t t t t t t tR R Q k d R BB

1 11

1 1

( )(1 ) ,(1 )

δµδ

+ ++

+ +

− −=

+ −t t

tt t

Q FSVMPK Q

Liquidity Intermediary (1)

• Demand for liquidity services:

• To provide liquidity services, LI requires real and financial (“excess reserves”) resources

, , where are liquidity servicesυ=t D t tlq k lq

1 1min[ ; ], where is in units of final goods, and is "excess reserves"

lq xrt t tlq n xr n

xr

α α− −=

Liquidity Intermediary (2)

• Maximize benefits derived from the use of deposits:

• Allocation of funds:

, ,( / )

max (1 ) IB MA RE D tt t t t t t tD

n s D P t

Ds R s R R PnR

− + − −

0 1 tsMAts

Reserve Requirement

Exc. Reserves

Lending to Interbank Market

Liquidity Intermediary (3) • Optimal condition for liquidity intermediary:

• Fire sale (or “cash-in-the-market”) price:

• Equilibrium in the interbank market:

1

(1 )

(1 ) [ ]

α

−

−=

= − −

lq tIB Dt t t

tIB MA D MAt t t t

lqR g R

xrR s R s

(1 )t t tB s D= −

1 1( ) (1 )(1 ) [ ]η υ η δ + += − + + − −t k t t t k t t tFS Q f g E sd FS

Nominal friction • Wholesale producers sell differentiated goods,

a composite of domestic and imported goods • Set sticky prices a-la-Calvo →Phillips curve:

1 1

1 *,

log(1 ) [log(1 )] log(1 )1 1

(1 )(1 ) + log , where

(1 )

marginal cost is: (1 )d

pt t t t

p p

p p t

p p ss

y t t tt d d

t t

E

mgcrmgc

P e PmgcrP P

θ

χβπ π πβχ βχ

φ βφφ βχ

α α

+ −

−

+ = + + ++ +

− − +

= − +

11 1d dθ θ− −

Aggregate Equilibrium

• Aggregate (domestic) demand is given by

• And is equal to the supply of final goods

(adjusted by the price distortion or nominal friction “disp”)

,t t k t t tda c c inv n= + + +

1,( )t t s tda disp y−=

Summary of Spread Determinants

• The spread between the lending rate and the deposit rate is determined by leverage and liquidity conditions; policy instruments:

.

/ , ; l d MA

macro pruleverage liquidity policy instr

R R f QK N Q FS sµ−

= × −

Calibration • Macro-parameters: standard • Financial system parameters: (i) annual default rate of 3 percent (in line with BGG); (ii) a leverage ratio of 40 percent (mid-point between BGG

and estimate from Gonzalez-Miranda (2012) ); (iii) an average cost of liquidation of 60 percent • These parameter values imply:

– – a recovery rate of around 36 percent – entrepreneurs’ debt/credit is 55 percent of annual GDP – deposits, as percentage of annual GDP, is 61 percent – Excess reserves as percentage of annual GDP of 0.15 percent

R 13.7% 6.6%, 4.5%, 4% (in annual basis)= > = = =K l IB DR R R

Alternative Policies

• We consider four alternative “regimes” 1. Standard Taylor rule and constant reserve

requirement (RR) 2. Inflation Targeting and constant RR 3. Augmented Taylor rule and constant RR

4. Inflation Targeting and countercyclical RR

log log(1 ) log( ) log( )1

IBt

t y t b tR y b

r πψ π ψ ψ

= + + + +

log logMAt t

xrMA

s xrs xr

φ

= −

forces and more debt/credit

0 5 10 15 20 250

0.5

1

1.5GDP

Dev

. fr

om S

S

0 5 10 15 20 25-2

0

2

4

6

8Investment

0 5 10 15 20 25-4

-2

0

2Real exchange rate

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1interbank rate

0 5 10 15 20 25-1

0

1

2

3aggregate demand

Dev

. fr

om S

S

0 5 10 15 20 25-4

-2

0

2

4default rate

0 5 10 15 20 25-0.8

-0.6

-0.4

-0.2

0inflation rate

0 5 10 15 20 25-4

-2

0

2

4Tobin Q

0 5 10 15 20 25-4

-2

0

2

4fire sale price

Dev

. fr

om S

S

0 5 10 15 20 250

1

2

3

4deposits (% SS GDP)

0 5 10 15 20 250

1

2

3

4ent. debt (% SS GDP)

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1deposit rate

0 5 10 15 20 25-0.1

-0.05

0

0.05

0.1excess of reserves (% SS GDP)

Dev

. fr

om S

S

Quarters0 5 10 15 20 25

0

2

4

6

8

10Foreign debt (% SS GDP)

Quarters0 5 10 15 20 25

-10

0

10

20

30networth (% SS GDP)

Quarters0 5 10 15 20 25

-2

-1

0

1

2Loan rate

Quarters

Natural Price rigidities, financial frictions+IT regime Price rigidities, financial frictions+augmented Taylor rule

Alternative policies (w/o MaPP)

0 5 10 15 20 25-1

-0.5

0

0.5

1Reserve requirement (% Deposits)

Dev

. fr

om S

S

Quarters

0 5 10 15 20 25-3

-2

-1

0

1

2Cost of Liquidation

Quarters0 5 10 15 20 25

-2

-1

0

1

2

3Recovery Rate

Quarters

Policy Framework

Welfare

Losses (+)/ gains (-) expressed relative to the deterministic SS welfare in terms of SS consumption

IT regime -16.7788 0.08%

Augmented Taylor rule -16.8425 0.13%

Standard Taylor rule -16.9033 0.16%

0 5 10 15 20 250

0.5

1

1.5GDP

Dev

. fr

om S

S

0 5 10 15 20 25-2

0

2

4

6

8Investment

0 5 10 15 20 25-4

-2

0

2Real exchange rate

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1interbank rate

0 5 10 15 20 25-1

0

1

2

3aggregate demand

Dev

. fr

om S

S

0 5 10 15 20 25-4

-2

0

2

4default rate

0 5 10 15 20 25-0.8

-0.6

-0.4

-0.2

0inflation rate

0 5 10 15 20 25-4

-2

0

2

4Tobin Q

0 5 10 15 20 25-4

-2

0

2

4fire sale price

Dev

. fr

om S

S

0 5 10 15 20 25-20

0

20

40deposits (% SS GDP)

0 5 10 15 20 25-1

0

1

2

3

4ent. debt (% SS GDP)

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1deposit rate

0 5 10 15 20 25-0.1

-0.05

0

0.05

0.1excess of reserves (% SS GDP)

Dev

. fr

om S

S

Quarters0 5 10 15 20 25

0

2

4

6

8

10Foreign debt (% SS GDP)

Quarters0 5 10 15 20 25

-10

0

10

20

30networth (% SS GDP)

Quarters0 5 10 15 20 25

-2

-1

0

1

2Loan rate

Quarters

Natural Price rigidities, financial frictions+IT regime Price rigidities, financial frictions+augmented Taylor rule Price rigidities, financial frictions+IT regime & countercyclical res. req.

Higher Welfare with Countercyclical RR

0 5 10 15 20 25-10

0

10

20

30Reserve requirement (% Deposits)

Dev.

from

SS

Quarters

0 5 10 15 20 25-3

-2

-1

0

1

2Cost of Liquidation

Quarters0 5 10 15 20 25

-2

-1

0

1

2

3Recovery Rate

Quarters

Policy Framework

Welfare

Losses (+)/ gains (-) expressed relative to the deterministic SS welfare in terms of SS consumption

3 Augmented Taylor type rule -16.8425 0.13% 4 IT regime and Countercyclical RR -14.6705 -1.27%

MP rate: coordinate with Macroprudential tool

• Tinbergen, Mundell principles • MP rate has to follow the “natural” rate and

be adjusted by the RR

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1interbank rate

Robustness: Dollarization (1) • Include foreign debt (denominated in dollars)

for entrepreneurs and credit intermediaries • More financial volatility, but same policy

ranking

Policy Framework Welfare

Losses (+)/ gains (-) expressed relative to the deterministic SS welfare in terms of SS consumption

1 Standard Taylor rule -16.6411 0.12% 2 IT Regime -16.4914 0.02% 3 Augmented Taylor rule -16.5111 0.03% 4 IT regime and Countercyclical RR -14.0664 -1.52%

Robustness: Dollarization (2) • Loans to entrepreneurs are denominated in

dollars. This also rises the volatility • Taylor rules “dominate” IT, MaPP improves the

welfare even more.

Policy Framework Welfare

Losses (+)/ gains (-) expressed relative to the deterministic SS welfare in terms of SS consumption

1 Standard Taylor type rule -16.3758 -0.18% 2 IT Regime -16.4643 -0.12% 3 Augmented Taylor type rule -16.3220 -0.21% 4 IT regime and Countercyclical RR -9.8920 -4.22%

Dollarization (2)

0 5 10 15 20 250

0.5

1

1.5GDP

Dev

. fro

m S

S

0 5 10 15 20 25-5

0

5

10Investment

0 5 10 15 20 25-4

-2

0

2Real exchange rate

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1interbank rate

0 5 10 15 20 25-1

0

1

2

3aggregate demand

Dev

. fro

m S

S

0 5 10 15 20 25-5

0

5

10default rate

0 5 10 15 20 25-0.8

-0.6

-0.4

-0.2

0inflation rate

0 5 10 15 20 25-5

0

5

10Tobin Q

0 5 10 15 20 25-5

0

5

10fire sale price

Dev

. fro

m S

S

0 5 10 15 20 25-40

-20

0

20

40

60deposits (% SS GDP)

0 5 10 15 20 25-4

-2

0

2

4

6ent. debt (% SS GDP)

0 5 10 15 20 25-1.5

-1

-0.5

0

0.5

1deposit rate

0 5 10 15 20 25-0.2

-0.1

0

0.1

0.2excess of reserves (% SS GDP)

Dev

. fro

m S

S

Quarters0 5 10 15 20 25

0

2

4

6

8

10Foreign debt (% SS GDP)

Quarters0 5 10 15 20 25

-20

0

20

40networth (% SS GDP)

Quarters0 5 10 15 20 25

-10

-5

0

5

10Loan rate

Quarters

Natural Price rigidities, financial frictions+IT regime Price rigidities, financial frictions+augmented Taylor rule Price rigidities, financial frictions+IT regime & countercyclical res. req.

Robustness: Wage rigidities • Only a fraction of workers adjust their wages to

labor market condition every period (Blanchard-Galí, 2007)

• This increases the responses of asset prices and defaults. Distortions reinforce each other and MaPP delivers more welfare benefits

Policy Framework

Welfare Losses (+)/ gains (-) expressed relative to the deterministic SS welfare in terms of SS consumption

1 Standard Taylor type rule -16.9331 0.18% 2 IT Regime -16.7133 0.04% 3 Augmented Taylor type rule -16.8458 0.13% 4 IT regime and Countercyclical RR -13.5116 -1.99%

Case Study 2: Conclusion

• A countercyclical macroprudential policy is better suited to manage the volatility of world interest rates and associated capital flows

• Conclusion is robust to different combinations of nominal and financial frictions (other MaPP instruments? Probably, see next)

• Inflation Targeting continues to be the main monetary policy objective, but MP rate must accommodate moves in the “natural” interest rate and reserve requirements

Bianchi: Equivalence Between Reserve and Capital Adequacy Requirements

Bianchi’s Equivalence Result

Macroeconomic Costs of Higher CAR

• Based on Rogers and Vlcek (IMF WP/11/103) • Model similar to Gerali et al • The macroeconomic impact of a 2% increase

in CAR depends on: – Banks optimal response: increase spreads, reduce

dividends or lending – Monetary policy response – Implementation period

Macroeconomic Costs of Higher CAR

• The increase in CAR happens gradually over two years

• The least costly option is to reduce distribution of bank dividends

• But is not enough: next comes an increase in spreads

• Finally, last resort is a reduction in lending (with maximum negative impact on GDP)

Macroeconomic Costs of Higher Liquidity Requirements

• Two effects: – Lower bank revenues, thus higher spreads – Lower risky assets, thus less capital needed

• The last effect means that liquidity and CAR become complements; interaction effects are very important

• For a 25% increase in liquid assets, spreads increase only about 50 bps

BIS Assessment of Δ CAR

• Conducted with a battery of models, across several countries

• Results are similar to those just shown with IMF model

• Typically, output reduction is rather small • Contrast with industry estimates

Counter-cyclical Capital Buffers

• Using models similar to above examples, IMF (GFSR September 2011) estimates role of counter-cyclical capital buffers on financial and macro-economic stability

• Baseline is an asset price bubble that builds up financial imbalances

• Volatility of GDP and trade balance are much lower with counter-cyclical buffer (next)

Credit Boom in Open Economy • Model with simple FA (Unsal, IMF WP/11/189)

where an improvement in external conditions leads to capital inflow

• Imposing regulatory “premium” complements monetary policy (theme of afternoon workshop)

Final Thoughts on Model Use

• Models reviewed (and others) are showing promising results for a number of macro-prudential policy analyses

• The sources of shocks hitting the economy are critical

• Models could be used to deliver implications for other variables, to help decide whether an increase in credit growth is an imbalance (say, bubble) or genuine (due to productivity)

Final Thoughts on Model Use

• Successful use of models require deep understanding of transmission mechanisms, relation to data, and above all judgment

• However, some models ignore a number of important issues, many raised by recent crisis

• In particular, increased risk-taking, bank runs and asset price bubbles

• Need to be complemented with indicators of build-up of imbalances and financial intelligence

Final Thoughts

• Monetary and Macro-Prudential Policies are broadly complementary

• Models are useful, if used with judgment • Financial Stability is a central bank objective,

to be achieved with appropriate weight to monetary and macro-prudential tools

• It is critical to identify the source of shocks: financial or others; models and indicators useful for this as well

Thank You!