Leaning Against Boom-Bust Cycles in Credit and Housing Prices
30 Pages Posted: 25 Mar 2011 Last revised: 21 Feb 2012
Date Written: March 18, 2011
This paper studies the potential gains of monetary and macro-prudential policies that lean against news-driven boom-bust cycles in housing prices and credit generated by expectations of future macroeconomic developments. First, we find no trade-off between the traditional goals of monetary policy and leaning against boom-bust cycles. An interest-rate rule that completely stabilizes inflation is not optimal. In contrast, an interest-rate rule that responds to financial variables mitigates macroeconomic and financial cycles and is welfare improving relative to the estimated rule. Second, counter-cyclical Loan-to-Value rules that respond to credit growth do not increase inflation volatility and are more effective in maintaining a stable provision of financial intermediation than interest-rate rules that respond to financial variables. Heterogeneity in the welfare implications for borrowers and savers make it difficult to rank the two policy frameworks.
Keywords: Expectations-driven cycles, Macro-prudential policy, Monetary policy, Welfare analysis
JEL Classification: E32, E44, E52
Suggested Citation: Suggested Citation