Prudential Monetary Policy

58 Pages Posted: 2 Jun 2019 Last revised: 24 Apr 2020

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Alp Simsek

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: March 14, 2019

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.

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

Caballero, Ricardo J. and Simsek, Alp, Prudential Monetary Policy (March 14, 2019). Available at SSRN: https://ssrn.com/abstract=3385769 or http://dx.doi.org/10.2139/ssrn.3385769

Ricardo J. Caballero (Contact Author)

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Alp Simsek

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