Expectations, Financial Markets and Monetary Policy

Abstract: Monetary Policy and Macroprudential Regulations. We investigate the desirability of macroprudential regulations in a DSGE model with collateral and income borrowing constraints. We differentiate between credit demand and credit supply oriented macroprudential regulations by letting the macroprudential authority tighten, or relax, the financial constraints of borrowers and lenders separately. Additionally, we allow the central bank to use a Taylor rule augmented with credit growth targeting. Using a loss function in inflation and output for the central bank, we find that macroprudential regulations may help to decrease the volatility of inflation and output following a financial shock in the credit market. We analyse numerous policy configurations, and the loss function is minimized when the central bank aggressively responds to deviations of inflation and output, but not of credit growth, from their steady-state values and the macroprudential authority aggressively responds to deviations of credit growth and house price growth from their steady-state values. Given the monetary policy configuration that minimizes the loss function, credit demand macroprudential regulations appear to be more effective than their credit supply counterparts in minimizing the volatility of inflation and output.