Optimal Monetary and Macroprudential Policies

43 Pages Posted: 13 May 2021

See all articles by Josef Schroth

Josef Schroth

Government of Canada - Bank of Canada

Date Written: May 12, 2021

Abstract

This paper studies monetary policy in an economy where banks make risky loans to firms and provide liquidity services in the form of deposits to households. For given bank equity, market discipline implies that banks can take more deposits when assets are safer or more profitable. Banks respond to loan losses by making their balance sheets safer\textemdash i.e., they reduce risky lending sharply and accumulate more safe bonds. In contrast, a social planner would respond by making banks temporarily more profitable such that a riskier balance sheet can be maintained. A planner would temporarily reduce the expansiveness of monetary policy to avoid bonds becoming too liquid in support of the liquidity premium banks earn via deposits. Specifically, when bank equity is low, then optimal monetary policy stabilizes output by supporting bank lending rather than employment.

Keywords: Financial frictions, Financial intermediation, Market discipline, Access to funding, Macroprudential capital regulation, Monetary policy

JEL Classification: E44, E60, G21, G28

Suggested Citation

Schroth, Josef, Optimal Monetary and Macroprudential Policies (May 12, 2021). Available at SSRN: https://ssrn.com/abstract=3845028 or http://dx.doi.org/10.2139/ssrn.3845028

Josef Schroth (Contact Author)

Government of Canada - Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

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