Optimal Monetary and Macroprudential Policies

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Banks are key providers of liquidity, and their access to funding depends on the liquidity of their own assets. During financial crises, banks may reduce holdings of less liquid assets, such as business loans, and this may worsen the economic cost of crises. On the one hand, macroprudential policy-makers should be concerned with how banks change the composition of assets on their balance sheets during financial crises. On the other hand, monetary policy authorities can support financial stability by considering the effects on bank loan supply. This is because these authorities directly affect the liquidity of assets traded on financial markets.

This paper studies how monetary and macroprudential policies should be coordinated to optimize the supply of both loans and liquidity for household welfare. It develops a model of recurring financial crises. In this model, the interest rate that banks must pay on deposits depends on both bank deposit supply and monetary policy actions. When monetary policy is expansive, it competes with banks to provide liquidity, which reduces the liquidity premium they enjoy. A lower liquidity premium reduces the liquidity of bank assets by lowering banks’ “skin in the game,” and thus reduces their access to funding.

There are two main policy implications. First, monetary policy should be less expansive during recoveries from financial crises than what would be needed to close the labour gap. Second, macroprudential policy should require banks to shift away from safe bonds during financial crises. This shift would reduce the supply of bank deposits so that deposit rates are also further reduced. Regulators should aim for bank balance sheets that are larger and safer during normal times but smaller and riskier during financial crises.

DOI: https://doi.org/10.34989/swp-2021-21