VoxEU Column Global crisis Macroeconomic policy

Monetary and macroprudential policies

The global financial crisis has prompted an intense debate on the role of macroprudential policies in limiting the accumulation of risks and imbalances. Major economies have recently established new institutions, or strengthened existing ones, with a mandate to pursue financial stability. This column examines the effectiveness and consequences of macroprudential policies with a focus on their interaction with monetary policy.

The recent debate on macroprudential policies moves from the idea that a regulatory gap – the fact that no authority was explicitly in charge of controlling systemic risk – has played an important role in the financial crisis. Indeed, microprudential supervisors typically focus on individual institutions, and therefore are liable to neglect risks outside their purview, such as those that can be negligible at the individual institution level but may add up in the aggregate. Central banks concentrate on the primary goal of price stability, and may not be sufficiently concerned about financial stability. Furthermore, various sectors of the financial system often fall under the responsibility of different authorities, making it difficult to conduct a thorough analysis of systemic risk, let alone act upon it.

These considerations, looming large in the regulatory agenda, have fostered the establishment of new institutions with the mandate to preserve financial stability (in the EU, the European Systemic Risk Board; in the US, the Financial Stability Oversight Council), or the strengthening of the powers of existing ones (the Bank of England has been assigned full responsibility for macroprudential policy).

To reduce the probability and the impact of a financial bust, macroprudential authorities will have to contrast the build-up of risks during the positive phases of the business or financial cycle, and mitigate the credit contraction or the excessive risk aversion during downturns. Potential instruments to be used to this end include countercyclical capital requirements (such as those envisaged in the recently approved Basel III reform package) and loan-to-value ratios, which some countries (South Korea, China, Singapore, and Hong Kong) have recently used.

Clearly, policies relying on these instruments partially overlap with other policies that also aim at moderating business cycle fluctuations, first and foremost monetary policy. Indeed, monetary policy affects asset prices and credit, which are relevant variables for macroprudential policy. At the same time, macroprudential policy has an impact on these variables, and thus is likely to influence the transmission mechanism of monetary policy.

In a recent paper (Angelini et al. 2011), we analyse the strategic interaction between monetary policy and macroprudential policy within the context of an estimated macroeconomic model of the Eurozone with a banking sector (Gerali et al. 2010). Our modelling of monetary policy is standard. We assume that the central bank sets the parameters of a Taylor rule to minimise the variance of inflation and output. By contrast, modelling of macroprudential objectives and instruments is uncharted territory. Thus, we adopt a positive approach, drawing on the goals stated and the actions taken by policymakers. Concerning the objective, there is broad consensus on the need to avoid “excessive” lending to the private sector and to contain the cyclical fluctuations of the economy (Bank of England 2009). This can be modelled by assuming that the macroprudential authority is concerned about the variance of the loans-to-output ratio and of output. As for the instruments, we assume that the macroprudential authority adjusts banks’ capital requirements (our results turn out to be reasonably robust when we use a loan-to-value ratio as an alternative instrument).

Two types of interaction are considered.

  • In the first, which we call the cooperative case, the central bank and the macroprudential authority are assumed to act as a single policymaker, jointly and simultaneously implementing their policies in order to minimise a common objective function.
  • In the second, non-cooperative, case each authority minimises its own objectives, taking the policy of the other as given.

The results from these two cases are compared with a “monetary policy-only” environment, in which the central bank alone is in charge of stabilising the economy.

Overall, we find that macroprudential policy can improve macroeconomic stability. However, this finding needs important qualifications.

  1. In “normal” times, when the economic cycle is mainly driven by supply shocks (technology shocks in our model), macroprudential policy yields negligible benefits relative to a “monetary policy-only” world, even if the two authorities cooperate. Furthermore, lack of cooperation may lead to excessive volatility of the policy tools (the short-term interest rate and the capital requirement). This result reflects the fact that macroprudential policy and monetary policy affect closely related variables, so at times they may push in different directions. That is, the central bank reacts to a negative technology shock by loosening its stance, but this leads the macroprudential authority to tighten the capital requirement, which in turn induces a further monetary easing. This vicious circle does not materialise in the cooperative case (see also Bean et al. 2010).
  2. The benefits of macroprudential policy become more sizeable when economic fluctuations are driven by financial or housing market shocks that affect the supply of loans, and become greater when the central bank and the macroprudential authority cooperate closely. In this case the cooperative equilibrium is characterised by lower volatility of output and loans-to-output ratio, but also by systematically higher inflation volatility, relative to the non-cooperative case or to the “monetary policy-only” case. The central bank lends a hand to the macroprudential authority, taking care of objectives that are broader than price stability in order to improve the overall stability of the economy.

Taken together, these results suggest that the benefits of macroprudential policies depend crucially on the source of the shocks that hit the economy, and on the extent of coordination with monetary policy. If used improperly, macroprudential policy could generate undesired variability in interest rates and banks’ capital requirements without much improvement in other areas. Thus, macroprudential policies should neither be considered as a substitute for monetary policy nor an all-purpose stabilisation tool. Rather, they should be viewed as a useful complement to traditional macroeconomic policies in a world in which financial shocks have become an important source of macroeconomic fluctuations.

Why macroprudential policies now?

Our findings offer an explanation of why the major countries have introduced macroprudential frameworks only recently. In the previous decades, given the prevalence of real shocks among the determinants of economic dynamics, the policies aiming at macroeconomic stability were centred on monetary policy, arguably the most powerful tool in such a framework. However, the global financial crisis has fostered the view that new instruments may be needed to cope with an economic environment in which financial shocks have become important. Put differently, macroprudential policies have been introduced only recently because it is now, with the global financial crisis, that the need for such policies has been felt.

It is also worth noting that the differences between cooperative and non-cooperative outcomes are important in the light of the institutional arrangements that are taking shape in the main countries, featuring important differences in the relationship between the macroprudential authority and the central bank. At one extreme, the Bank of England has been assigned full responsibility for macroprudential policy. In the European Union, meanwhile, central banks have a prominent role in the European Systemic Risk Board, although other institutions (e.g. financial supervisors) are also represented. On the opposite extreme we have the US. The Federal Reserve System participates in the Financial Stability Oversight Council, but has no privileged role apart from what is justified by its superior skills in macroeconomic and financial analysis. Each of these institutional setups has pros and cons. A framework with two independent authorities may improve accountability and reinforce the commitment needed to achieve objectives. However, as our results suggest, this framework may be prone to coordination failures.

The generality of our results is far from being established, as they are conditional upon many assumptions and methodological choices. Probably the greatest shortcoming of our model – and of most modern macro models in general – is the lack of explicit modelling of systemic risk, arguably the distortion that macroprudential policy should address. Systemic risk is extremely hard to define and measure, as it may emerge from a variety of sources and evolve over time. These difficulties warrant the conclusion that systemic risk defies thorough modelling, and that it can only be captured in limited, ad-hoc ways. Improving this aspect is an important avenue for future research. Adequate models should include the financial externalities and proxies of systemic risk to be tackled by macroprudential policies; they should be complex enough to allow for a meaningful interaction between monetary and macroprudential policy and they should probably feature an important role for nonlinearities.


Angelini, P, S Neri and F Panetta (2011), “Monetary and macroprudential policies”, Bank of Italy, Temi di Discussione 801.
Bank of England (2009), “The role of macroprudential policy”, Discussion paper.
Bean, C, M Paustian, A Penalver and T Taylor (2010), “Monetary policy after the fall”, paper presented at the Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole, Wyoming.
Gerali, A., S Neri, L Sessa and FM Signoretti (2010), “Credit and Banking in a DSGE Model of the Euro Area”, Journal of Money, Credit and Banking, 42(6):107-141.


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