Discussion Paper Details

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Title: Prudential Monetary Policy

Author(s): Ricardo Caballero and Alp Simsek

Publication Date: June 2019

Keyword(s): aggregate demand, Business cycle, effective lower bound, leaning against the wind, leverage, macroprudential policies, monetary policy, regulation, Shadow banks and Speculation

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

Abstract: Should monetary policymakers raise interest rates during a boom to rein in financial excesses? We theoretically investigate this question using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, there are conditions under which small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors' balance sheets. The policy is most effective when the recession is more likely and leverage limits are neither too tight nor too slack. With shadow banks, whether PMP "gets in all the cracks" or not depends on the constraints faced by shadow banks.

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Bibliographic Reference

Caballero, R and Simsek, A. 2019. 'Prudential Monetary Policy'. London, Centre for Economic Policy Research.