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Abstract
This article introduces macroprudential policy using a static New Keynesian Macroeconomics model with financial frictions. The authors analyze two related questions: First, they show how the procyclicality of financial factors, captured by the financial accelerator, amplifies the transmission of supply and demand shocks and impacts the intuition they get from a basic intermediate macroeconomics. Second, adopting an optimal policy perspective, they show how a policymaker may use macroprudential policy to complete monetary policy measures. Following the Mundellian Policy Assignment principle, macroprudential policy should be specialized to address the procyclicality problem to suppress welfare losses associated with the building of financial imbalances, thus helping monetary policy to concentrate on the output inflation tradeoff.
ACKNOWLEDGEMENTS
We thank the editor and two anonymous referees for their constructive remarks on a first version of this article. We are grateful to Thibaud Cargoët, Jean-Sebastien Pentecôte, and Fabien Rondeau for helpul discussions and comments on the initial version of this article.
Notes
This article should thus be considered as a possible complement to Walsh (Citation2002) (which presents the main features of inflation targeting in a precrisis environment); Bofinger, Mayer, and Wollmershäuser (Citation2006) (which presents both a compact way of introducing the 3-equation New Keynesian Model and that introduces the students to the debate between simple and optimal monetary rules); Friedman (Citation2013) (which discusses the way unconventional monetary policy measures should be conducted in a New Keynesian Model following the financial crisis); Buttet and Roy (Citation2014) (which offers a simple treatment of the question of conduct of monetary policy at the zero lower bound); and Woodford (Citation2010) (which presents the way financial intermediation should be integrated into macroeconomic analysis and how it should be taken into account for the conduct of monetary policy).
The microfoundation of this relation is provided in appendix.
The solution procedure is as follows: Combining the targeting rule with the Phillips curve, we get a solution for either the output gap or the inflation gap; combining the solution for the output gap with the loan market equilibrium condition, we get the interest rate gap.
An extensive presentation of this situation is proposed by Bofinger and colleagues (Citation2006).
See appendix for further details.
As suggested by Gelain and Ilbas (Citation2014), the output gap in the macroprudential authorities’ loss function reflects the concern to stabilize the indirect effects coming from financial imbalances that are not included in the monetary authority's loss function but could affect the real economy even in the presence of price stability. This modeling choice is useful to account for the Basel III regulation that refers to “reducing the risk of spillover from the financial sector to the real economy” as one of the main objectives of the regulatory reforms (BCBS 2011, 1). Furthermore, Angelini, Neri, and Panetta (Citation2011) adopted a similar approach to address financial disruption in order to avoid negative real economy effects.