Prudential Monetary Policy
58 Pages Posted: 2 Jun 2019 Last revised: 6 Sep 2019
Date Written: September 5, 2019
Should monetary policy have a prudential dimension? That is, should policymakers raise interest rates to rein in financial excesses during a boom? We theoretically investigate this issue 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, 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. An alternative intuition is that PMP raises the interest rate to create room for monetary policy to react to negative asset price shocks. The policy is most effective when there is extensive speculation and leverage limits are neither too tight nor too slack. When shadow banks are present, PMP can still replicate the benefits of macroprudential policy, but PMP is less effective (like macroprudential policy) because shadow banks respond by increasing their leverage.
Keywords: Speculation, leverage, aggregate demand, business cycle, effective lower bound, monetary policy, regulation, macroprudential policies, leaning against the wind
JEL Classification: E00, E12, E21, E22, E30, E40, G00, G01, G11
Suggested Citation: Suggested Citation