THE INTERACTION OF MONETARY AND MACROPRUDENTIAL POLICIES
THE INTERACTION OF MONETARY AND
MACROPRUDENTIAL POLICIES
EXECUTIVE SUMMARY
The recent crisis showed that price stability does not guarantee macroeconomic
stability. In several countries, dangerous financial imbalances developed under low
inflation and small output gaps. To ensure macroeconomic stability, policy has to
include financial stability as an additional objective. But a new objective demands new
tools: macroprudential tools that can target specific sources of financial imbalances
(something monetary policy is not well suited to do). Effective macroprudential policies
(which include a range of constraints on leverage and the composition of balance
sheets) could then contain risks ex ante and help build buffers to absorb shocks ex post.
Experience and knowledge on the effectiveness of macroprudential policies, their
calibrations, interactions among financial distortions and macroprudential tools, and
interactions of those tools with monetary policy ones are still limited at this juncture.
With this caveat in mind, the analysis in this paper provides the following findings:
Ideally, with macroprudential policies perfectly targeting the sources of threats to
financial stability, monetary policy should remain primarily focused on price and output
stability. That said, even in this ideal world, the conduct of both policies will need to
take into account the effects they have on each other’s main objectives.
In practice, however, policies face constraints. As knowledge is still limited,
macroprudential policies cannot be targeted perfectly and do not fully offset financial
shocks or distortions; institutions are imperfect; and time inconsistency and political
economy constraints can arise. Should these weaknesses prove important, monetary
policy may have to take a greater role in preserving financial stability and accept the
associated trade-off. Similarly, where monetary policy is constrained, as within currency
unions and in many small open economies, there will be greater demands on
macroprudential policies. Nonetheless, using macroprudential policies to offset
shortcomings in weakly conducted monetary policy is rarely optimal.
The interaction between monetary and macroprudential policies has implications for
institutional design. Policy coordination can improve outcomes, making it
advantageous to assign both policies to the central bank. But concentrating multiple
(and sometimes conflicting) objectives in one institution can muddy its mandate,
complicate accountability, and reduce credibility. Safeguards are then needed, with
institutional frameworks to distinguish between the two policy functions through
separate decision-making, accountability, and communication structures.
January 29, 2013
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Approved By
Olivier Blanchard and
José Viñals
Prepared by a staff team coordinated by Stijn Claessens (RES) and Karl
Habermeier (MCM) and comprising Erlend Nier, Heedon Kang,
Tommaso Mancini-Griffoli (MCM), and Fabian Valencia (RES).
CONTENTS
I. INTRODUCTION ________________________________________________________________________________ 3
II. CONCEPTUAL FRAMEWORK __________________________________________________________________ 4
A. Policy Goals and Assignment of Tools __________________________________________________________ 5
B. Interactions ______________________________________________________________________________________ 9
III. EXPERIENCES AND LIMITATIONS __________________________________________________________ 14
A. Imperfect Macroprudential Policies ___________________________________________________________ 14
B. Constraints on Monetary Policy _______________________________________________________________ 17
C. Institutional and Political Economy Considerations ___________________________________________ 18
IV. CONCLUSIONS ______________________________________________________________________________ 21
BOXES
1. Aggregate Consequences of Financial Market Imperfections ___________________________________ 7
2. Channels through Which Monetary Policy Can Affect Financial Stability ______________________ 10
3. Interactions Between Monetary and Macroprudential Policies ________________________________ 12
4. Monetary and Macroprudential Policies in Small Open Economies ___________________________ 18
FIGURE
1. Policies and Objectives __________________________________________________________________________ 6
ANNEXES
I. Price, Output, and Financial Stability ___________________________________________________________ 23
II. Literature on Channels Through Which Monetary Policy Can Affect Financial Stability _______ 25
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I. INTRODUCTION
1. In the decades prior to the crisis, macroeconomic management evolved to assign a
strong role to monetary policy, with a primary focus on price stability. The framework of
monetary policy was broadly converging toward one with an inflation target (explicit or implicit) and
a short term interest rate as a tool (Blanchard, Dell’Ariccia and Mauro, 2010). Fiscal policy played a
limited role in macroeconomic management. Academic and policy thinking supported this strategy,
reinforced by decreased macroeconomic volatility during the Great Moderation (Annex I provides
some empirical evidence for selected crisis countries) as the best way to stabilize both the
macroeconomy and the financial system.
2. While boom-bust cycles in asset prices and credit were observed prior to the recent
crisis, these did not seriously challenge the prevailing paradigm. Several proponents argued in
favor of more “leaning against the wind” (Blanchard, 2000, Borio and White, 2003). But the opposing
view argued that by keeping monetary policy focused on price and output stability, it would deliver
the best feasible outcome (Bernanke and Gertler, 1999, 2001). Meanwhile, at least in most
economies, prudential policies were focused narrowly on the soundness of individual firms.
3. Price stability, however, did not ensure macroeconomic stability and the crisis has
strengthened calls for the use of financial regulation focused on macro-financial risks:
macroprudential policies. Financial instability has undermined macroeconomic stability, despite
low and stable inflation. This means that additional tools will be helpful in complementing monetary
policy in countercyclical management. Macroprudential tools emerge as candidates. Because there is
no single tool that influences all financial behavior consistently, a variety of tools is needed, from
procyclical capital adequacy requirements to loan-to-value caps (LTV’s), taxes/levies, and constraints
on the composition of assets and liabilities of financial institutions. Several of these tools have a
long history, but were mostly used for microprudential or monetary objectives (Federico et al., 2012;
Tovar and others, 2012). Emerging market economies have been pioneers in refocusing those
instruments on macroprudential uses.
4. As macroprudential policy frameworks are being developed, policymakers are
increasingly turning their attention to the relationship between macroprudential and
monetary policies. The newly emerging paradigm is one in which both monetary policy and
macroprudential policies are used for countercyclical management: monetary policy primarily aimed
at price stability; and macroprudential policies primarily aimed at financial stability. The relationship
between monetary and macroprudential policies hinges on the “side effects” that one policy has on
the objectives of the other and how perfectly each operates in the pursuit of its own primary goal
(Gerlach and others, 2009). These interactions can enhance or reduce the effectiveness of each
policy in achieving its objectives and therefore suggest the need for coordination.
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5. This paper examines the conduct of both monetary and macroprudential policies in
the presence of interactions. The paper starts with a conceptual review of how both policies would
be conducted optimally considering their interactions. While structural models now available offer
clear insights, they do not take into account important frictions that affect policy interactions in the
real world. The paper therefore addresses three additional questions: if macroprudential policies
work imperfectly, what are the implications for monetary policy? If monetary policy is constrained,
what is the role for macroprudential policies? And if there are institutional and political economy
constraints, how can macroprudential and monetary policies be adjusted?
6. In addressing these issues, the paper builds on other work, a review of the growing
literature, and is part of a larger effort. Previous work includes Board papers on macroprudential
policies, notably on the organizing framework (IMF 2011a), the effectiveness of macroprudential
instruments (Lim and others, 2011), and institutional models for macroprudential policies (Nier and
others, 2011). The paper is also informed by a range of new country case studies and empirical
evidence collected in an accompanying background paper. It is part of a larger effort, including
forthcoming staff papers on unconventional monetary policy, the costs of macroprudential policies,
and the relationship between macro- and microprudential policies. And, in accordance with the 2011
Triennial Surveillance Review, and the 2012 Financial Surveillance Strategy, it contributes to the
Fund’s work on financial stability.
7. The paper does not seek to cover all aspects of macroprudential policy and comes with
caveats. It is important to clarify that, while this paper draws out the institutional implications of the
interactions between monetary and macroprudential policies, there are broader institutional
considerations that are left for future work by MCM and LEG (including the upcoming Board paper
on “Key Aspects of Macroprudential Policy”). Similarly, macroprudential policies may generate costs
and face constraints, which may undermine their effectiveness. While the paper touches upon those
issues, it does so only to the extent that they also affect the interaction with monetary policy since a
comprehensive coverage is outside the scope of the paper. The paper also reflects the tentativeness
of the state of knowledge and experience on macroprudential policies. Its main contributions are
rather an analytical framework for the interactions of macroprudential policies with monetary policy,
and operational insights given these interactions in light of various constraints.
II. CONCEPTUAL FRAMEWORK
8. Perfectly functioning macroprudential and monetary policies imply no major changes
in the conduct of each policy. This section describes an ideal benchmark in which both policies
operate perfectly, in the sense that they effectively target the distortion of concern, do not generate
additional distortions, and do not face other institutional or political economy constraints. While this
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benchmark is most likely unattainable, it is a necessary first step to anchor the analysis. Departures
from this ideal world, which are considerable, are discussed in the next section.
1
A. Policy Goals and Assignment of Tools
9. When price rigidities are the only distortion, stabilizing inflation is generally
equivalent to maximizing welfare. The ultimate goal of policy is to ensure the best attainable level
of welfare, which implies achieving an efficient level and composition of output. To this end, policy
has intermediate goals related to mitigating distortions that reduce welfare. When price rigidities are
the only distortion, standard monetary economics arrives at a fairly clear cut conclusion: monetary
policy should aim at stabilizing inflation as a means to eliminate the distortions in the dispersion of
output generated by price rigidities (Woodford, 2003). By keeping monetary policy focused on price
stability, output stability is guaranteed and the best feasible outcome is obtained. When other
rigidities in the non-financial economy are present, this result needs to be qualified, leading to a
tradeoff between stabilizing output and inflation (Blanchard and Gali, 2007). But even then, inflation
stabilization receives a large weight.
10. When financial distortions are present, price stability is not sufficient for welfare
maximization and financial stability becomes an additional intermediate policy goal. In the
presence of financial market imperfections, individual behavior is distorted, giving rise to excessive
risk-taking ex ante—in the form of excessive leverage, large exposure to risky assets, and fragile
liability compositions—and negative asset-price or exchange-rate externalities ex post (Box 1). In
short, boom-bust cycles are amplified.
2
When these distortions vary over time, or respond to
economic conditions, and affect one sector of the economy more than others, as generally is the
case, there will also be a distortion in the composition of output (Curdia and Woodford, 2009;
Carlstrom and Fuerst, 2010). Welfare maximization then requires adding financial stability as an
intermediate goal for policy, because financial instability signals distortions in the level and/or
composition of output (Figure 1).
11. Operationalizing financial stability is made difficult by the large range of financial
distortions and their changes over time. Policy and academic thinking have converged on what is
considered price stability: low and stable inflation. Knowledge on financial stability, however, is
incomplete in many respects, such as the interactions across financial distortions and the changing
nature of financial distortions. Factors such as the degree of financial development and the exchange
rate regime can greatly affect the types of risks that arise (see the background paper for case studies
on Emerging Europe, Brazil, Korea, Turkey, and the United States). Excessive leverage in the corporate
1
More generally, both monetary and macroprudential policies have to be set in consideration of the broader
macroeconomic context. These include, besides financial stability conditions, the stance of other policies, notably
fiscal policy. These other considerations are acknowledged, but not analyzed in this paper.
2
Bianchi (2011), Caballero and Krishnamurthy (2003, 2004), Lorenzoni (2008), Mendoza (2010), and Korinek (2010).
De Nicolò and others (2012) provide a review of the financial distortions that give rise to systemic risk.
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sector may give way, for example, to excessive leverage in the household sector, and vice versa.
Liquidity conditions in domestic and international financial markets can change rapidly. It is therefore
not yet possible to operationalize financial stability to the same degree as price stability.
3
12. The task of preserving financial stability nonetheless remains clear: mitigating financial
distortions and the risks associated with them, with intermediate targets linked to the aggregate
implications of these distortions (for example, leverage in the banking or household sectors, capital and
liquidity positions of financial intermediaries, foreign exchange composition of assets and liabilities).
Figure 1. Policies and Objectives
Source: IMF
3
Numerical thresholds, for example, are at this stage of knowledge premature to consider, among others as they
depend on country circumstances.
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13. Monetary policy is not best suited to maintaining financial stability, and price and
output stability should thus remain its primary objective. Monetary policy alone cannot achieve
financial stability because the causes of financial instability are not always related to the degree of
liquidity in the system (which monetary policy can fix). While monetary policy can affect risk-taking
incentives and financial market conditions, mitigating the effects of financial distortions or pricking
an asset price bubble can require large changes in the policy rate (Bean and others, 2010).
Moreover, when financial distortions are more acute in some sectors of the economy than in others,
as is often the case, monetary policy is too blunt a tool. In these circumstances, price and output
stability conflict with financial stability and having additional tools for the financial stability goal can
increase welfare. Relying too much on monetary policy to deal with financial stability ex ante can
also create potential confusion of the public with regard to its objectives. In sum, keeping monetary
policy focused on its primary objective can create stronger commitment and reduce public fears the
central bank will be co-opted for other purposes.
Box 1. Aggregate Consequences of Financial Market Imperfections
Asymmetric information in financial markets, combined with limited liability or limits on enforcement,
leads to financial distortions. When there are information asymmetries, banks and borrowers can shirk (limit
efforts) or engage in moral hazard (“strategic defaults”). When there is limited enforcement, whether due to legal
or judicial limits, borrowing is constrained by how much lenders can recover in case of default (Hart and Moore,
1994), leading to collateral constraints. When there is limited liability combined with asymmetric information,
intermediaries do not internalize the cost that their bankruptcy imposes on lenders and take too much risk
(Townsend, 1979).
These distortions create externalities beyond the parties involved in a financial contract. Agents (borrowers and
banks) make financial decisions not internalizing their impact on the aggregate economy or financial system. When
agents individually undervalue the benefits of being financially prudent, this collectively means too much risk.
Because agents do not internalize their contribution to systemic risk, they take excessive leverage, liquidity risk,
exposure to a risky asset, or exposure to exchange rate risk. Excessive leverage figures prominently in all these
examples because agents increase borrowing in short-term debt or foreign currency debt to expand assets. When
times are bad, collateral constraints bind and trigger fire sales, further collateral tightening, and asset price spirals
(Lorenzoni, 2008; Mendoza, 2010; Bianchi, 2011; Adrian and Shin, 2012).
Strategic complementarities (it pays off to take more risk if others do it) can exacerbate this behavior.
Certain kinds of competition or expectations of bailouts will tend to reinforce strategic complementarities.
Expectations of aggressive monetary expansion (“Greenspan put”), or expectations of a fiscal bailout when a crisis
erupts, create incentives to correlate risks, because the more widespread the behavior, the more likely that a
bailout will take place (Farhi and Tirole, 2012).
Existing regulatory and tax regimes can also lead to excessive risk-taking. The existence of a differential tax
treatment between equity and debt, the tax deductibility of mortgage interest, and the use of non-recourse
mortgage loans distort incentives and can lead to excessive leverage or other forms of excessive risk-taking.
At the aggregate level, these imperfections imply amplification and persistence. In addition to implying an
inefficient steady state, any shock will generate a larger and longer-lasting response in aggregate variables than in
the absence of financial imperfections. The reason is that in their presence, capital does not flow frictionlessly to
where it is most productive (Kiyotaki and Moore, 1997).
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14. Macroprudential policies should focus on financial stability and are relatively less well
suited to managing aggregate demand. The use of macroprudential policies for managing
aggregate demand may in fact create additional distortions by imposing constraints on behavior
beyond those areas where financial distortions originate.
4
When other countercyclical tools (notably
monetary and fiscal policies) are available and effective, it is desirable to keep macroprudential
policies focused on financial stability. Moreover, while financial distortions can lead to economic
imbalances, such as an inefficient level or composition of output, this does not imply that these
imbalances, regardless of their source, are best addressed through macroprudential policies.
Assigning macroprudential policies a primary role in managing these imbalances is likely to
overburden them, with the key risk that policymakers overestimate what they can achieve.
15. The foremost role of macroprudential policies is to constrain (ex ante) the incentives for
excessive risk-taking. By constraining financial market participants’ behavior, macroprudential policies
force them to internalize their contributions to systemic risk and can reduce this risk, mainly over the
cycle but also across institutions.
5
Reflecting the variety of distortions, systemic risk can manifest itself in
different forms, including excessive leverage, weak lending standards and liquidity positions, and balance
sheet mismatches of financial institutions and borrowers. This variety explains the need for multiple
macroprudential tools, which will typically need to be adjusted in response to how macro-financial
conditions, including systemic risk, evolve.
6
Many of these tools are microprudential in nature––and thus
well-known—but are now being considered with financial stability objectives in mind.
16. There is a range of macroprudential tools, reflecting a variety of potential sources of
risk. Constraints on leverage are key as increases in leverage are a common manifestation of
excessive risk-seeking in theoretical work and a predictor of crises.
7
In the banking sector, tools
include countercyclical capital buffers (as used in Bulgaria and proposed internationally), dynamic
provisioning (as used in Spain and several countries in Latin America), reserve requirements (as used
in Brazil, Peru, and Turkey), and levies on short-term borrowing (as recently introduced in Korea). In
the household sector, LTV caps for mortgage loans and debt-to-income (DTI) limits can be used and
have already met with some success in a number of economies (including Hong Kong SAR, Korea,
and Poland). Excessive maturity mismatches or exposures to foreign exchange risk can justify tools
such as liquidity requirements and net open position limits. If borrowing is external, tools may
include capital flow management measures—including residency based measures—in certain
circumstances.
4
Costs, side-effects, and incentives for circumvention of macroprudential policies will be discussed in greater detail
in a forthcoming paper (Mitra and others, 2012).
5
Bank of England (2009), IMF (2011a), and De Nicolò and others (2012).
6
Our analysis focuses on macroprudential tools whose benefit is seen as containing “time series” risks, or the
“procyclical” increases in the risk of financial instability, it being understood that those macroprudential tools that are
expected to have benefits in containing the risk of failure of individually systemic institutions, or increase the
resilience of markets, are less likely to affect the regular conduct of monetary policy.
7
Dell’Ariccia and others (2012), Laeven and Valencia (2012), Kaminsky and Reinhart (1999), and Reinhart and Rogoff
(2009).
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17. The alternative is to preserve financial stability through reactive policies, but this entails
distortions and costs, which need to be mitigated through (further) ex-ante regulations. Dealing
with financial instability once it materializes allows policymakers to conduct targeted bailouts instead
of attempting to identify ex-ante excessive risk-taking or bubbles. But ex-post interventions can be
inefficient: they can overburden a (fiscally weak) sovereign, impose costs on taxpayers, and are not
always well-targeted. Most importantly, expectations of ex-post intervention can increase incentives to
take risks. Even if ruled out ex-ante by policymakers, private agents may expect ex-post public sector
interventions because they know it is too economically costly not to intervene. This implies that even if
some degree of ex-post interventions is used, macroprudential policies are needed to mitigate some
of their costs: they can reduce incentives for risk-taking created by expected bailouts and decrease the
intensity of any needed ex-post intervention.
B. Interactions
18. The use of each policy tool needs to take into account the side effects that they have on
the targets of the other. If financial distortions vary exogenously, each policy can pursue its goals
without being affected by side effects. The more realistic and typical case, however, is one in which
distortions respond to economic conditions and in particular to policy (for instance, when changes in the
policy rate affect incentives to take excessive leverage, and leverage is an intermediate target for
macroprudential policies). Side effects from monetary policy on macroprudential targets, and from
macroprudential policies on output and inflation, thus need to be considered.
19. It has long been recognized that monetary policy rates can affect agents’ decisions on
leverage and on the composition of assets and/or liabilities, by affecting the cost of borrowing,
domestic asset prices, and exchange rates. The literature on financial market imperfections has
identified a number of channels by which policy rates can affect financial decisions: (i) by shaping
ex-ante risk-taking incentives of individual agents, through leverage, short-term borrowing, or
foreign-currency borrowing; or (ii) by affecting ex-post the tightness of borrowing constraints and
possibly exacerbating asset price and exchange rate externalities and leverage cycles. (Box 2
discusses the various channels in more detail. Annex II reviews, for each channel, the predictions
from theoretical models and summarizes related empirical evidence).
20. First principles suggest that macroprudential policies well-targeted at the sources of
distortions have the potential to contain the undesirable effects of monetary policy. Appropriate
macroprudential policies can attenuate these side effects, thereby reducing policy dilemmas and
creating additional “room for maneuver” for monetary policy. For most of the channels discussed
above, a range of specific macroprudential instruments may reduce these effects when brought in ex-
ante. For example, the impact on defaults from a tightening of monetary policy can be contained by
having in place conservative limits on DTI ratios (Igan and Kang, 2011). When accommodative
monetary policy drives up asset prices, measures such as limits on LTV ratios can reduce vulnerabilities.
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Higher capital requirements, or tighter leverage or liquidity ratios can help contain increases in bank
risks in response to expected lax monetary policy (Farhi and Tirole, 2012).
8,
9
Box 2. Channels Through Which Monetary Policy can Affect Financial Stability
Changes in the monetary stance can affect the risk-taking behavior of financial intermediaries. With
asymmetric information, low monetary policy rates can create incentives for banks to over leverage or
reduce efforts in screening borrowers. Low rates can also lead other economic agents to seek more risks in
order to achieve higher returns. These effects are likely to be worse if monetary policy is too accommodative
for too long during expansions. Moreover, if monetary policy is expected to be eased during recessions to
support not only the real economy but also the financial system, the effect may be stronger because this
may give rise to additional incentives to correlate risks.
Changes in the monetary stance can affect the tightness of borrowing constraints and the likelihood
of default. Monetary easing relaxes collateral constraints, as asset prices rise and borrowers’ net worth
increases, and lowers the costs of external financing, thereby easing overall credit conditions. Conversely, a
tightening of rates can adversely affect borrowers’ capacity to repay, possibly leading to higher default rates
and financial instability.
Monetary policy can give rise to asset-price and exchange-rate externalities. By affecting asset prices
and exchange rates, monetary policy affects the value of collateral, which influences the tightness of
borrowing constraints. Low interest rate can increase asset prices, which can trigger excessive increases in
leverage and lead to asset price booms, exacerbating the financial cycle. Conversely, a tighter monetary
stance can cause collateral constraints to bind, fire sales to follow, with resulting adverse asset price
externalities. In open economies, interest rate increases can attract excessive capital flows, appreciating the
exchange rate, and leading to excessive borrowing in foreign currency and exchange-rate externalities in a
subsequent depreciation.
These channels may be operating simultaneously, with their strengths varying with the stage of the
cycle, financial structure, and other country characteristics. For example, incentives to correlate risks due
to the expectation of future monetary easing can be stronger in upswings. Effects can also depend on
financial structure and capital account openness. For example, structural changes modified the monetary
policy transmission channels prior to the crisis in the United States and Europe (Gambacorta and Marqués-
Ibáñez, 2011). Securitization generally reduces the strength of the effects of monetary policy on credit
extension by banks (Altunbas, and others 2012). In open and financially-integrated economies, domestic
monetary policy has a weaker influence on domestic long-term rates and asset prices, but exchange rate
externalities become more important.
21. Moreover, well-calibrated and clearly communicated macroprudential policies can
contain risks ex-ante, thereby easing the burden on monetary policy. Macroprudential policies
can help control unsustainable increases in credit and asset prices and mitigate procyclical feedback
8
English and others (2012) find empirically that a flatter yield curve is associated with lower net interest margins, with
the size of the effect increasing in the maturity mismatch between bank assets and bank liabilities.
9
To control increases in leverage outside the banking system associated with changes in policy rates, margin in
securities lending can be regulated (Kashyap and others, 2010; background paper, United States case study).
Measures, such as the Basel Net Stable Funding ratio, which encourage banks to seek stable and longer-term
funding, can reduce the incentive for intermediaries to seek risk in response to looser monetary policy conditions.
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between financial and real variables. While macroprudential policies should not be primarily used for
macroeconomic management, they can therefore facilitate it. Moreover, when macroprudential
policies constrain ex-ante risk-taking, they reduce the risk of financial distress.
22. Macroprudential tools can also provide buffers against unexpected shocks, lessening
the risk that monetary policy will run into the lower bound on interest rates. Releasing these
buffers in periods of tight financial conditions may cushion the effect of shocks on the provision of
credit and the economy. For instance, capital buffers can serve to complement monetary policy in
times of stress, by supporting the transmission of monetary policy and allowing for a smoother path
of monetary policy through the whole cycle (see the background paper). There is some evidence
from Spain, for example, suggesting that dynamic provisions do provide some relief in downturns
(Jimenez and others, 2012). Similarly, a tight LTV ratio can help contain the fall-out from a property
bust and keep open monetary transmission (background paper).
23. In principle, it can be appropriate to relax macroprudential tools in times of financial
stress. However, any such relaxation needs at the same time be consistent with ensuring the
resilience of the system to future shocks (CGFS, 2012). Moreover, evidence on the effectiveness of a
relaxation of macroprudential policies is still mixed at this time. One possible reason is because
markets have thus far tended to take an adverse view of reductions in prudential ratios during a
downturn.
10
It is not yet clear whether this will change in the future as markets’ understanding of
macroprudential policies becomes more settled.
24. Finally, macroprudential policies can affect the level of output and prices. By
constraining borrowing and hence expenditure in one or more sectors of the economy,
macroprudential policies affect overall output. In principle, these effects may differ with the
macroprudential tool being used, as well as the stage of the financial and economic cycle (as further
examined in the background paper).
11
The actual quantitative effects, however, are not well
understood because there is simply not enough data yet.
25. The sole presence of side effects has no major implications for the conduct of both
policies, however, when policies operate perfectly. If macroprudential policies have strong
effects on output, more accommodative monetary policy can offset these effects as necessary, as
10
Experiences after crises are that market discipline forces banks to keep higher capital buffers. Even though the
trade-off with risk to financial stability is not well-known, there is some evidence that relaxations of LTV and DTI
limits can help support house prices during downturns (Igan and Kang, 2012).
11
The background paper contains conceptual analysis of the transmission of a range of macroprudential tools,
including capital requirements, reserve requirements, and loan-to value ratios, to financial and real variables. It also
offers some (necessarily preliminary) empirical analysis of the relative strength of the effects across tools. See also
CGFS (2012) and ECB (2012).
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long as monetary policy is effective.
12
Conversely if changes in the monetary stance affect incentives
to take too much risk, certain macroprudential policies would need to be tightened.
Box 3. Interactions Between Monetary and Macroprudential Policies
A recent theoretical literature suggests that monetary and macroprudential policies are mainly
complements, not substitutes, although results vary by type of shock. Theoretical (mostly Dynamic Stochastic
General Equilibrium, DSGE) models with borrower collateral constraints and a banking sector generally assume
monetary policy controls the risk free interest rate and macroprudential policy the risk premium, or the spread
between lending rates and the risk free rate.
13
The objectives are output and price stability, and also credit growth.
Using different policy rules and shocks—financial, productivity or demand—the literature typically finds that it is
optimal to use monetary policy together with macroprudential policy. Moreover, using macroprudential policy to
achieve the same outcomes as monetary policy is inefficient, as it severely constrains the financial sector and
output.
These models imply that in the wake of a financial shock leading to financial stability concerns, it is optimal
to mainly use macroprudential policies. The macroprudential instrument is more targeted at the specific
financial sector distortion and monetary policy is too blunt (in the sense of also affecting all other macro variables)
to fight alone against a financial shock. This finding appears robust to open economy extensions. In open
economies, financial shocks can originate abroad and, more importantly, lead to an appreciation of the domestic
currency. While this limits inflation, when banks have foreign liabilities, it leads to financial amplification by
strengthening banks’ balance sheets, causing credit to expand. As a result, macroprudential policy needs to react
more and monetary policy less, but the interplay between the two does not change markedly (Agenor and others
2012; Unsal, 2011).
Following a productivity shock, conclusions depend on the nature of the financial distortions. Models with
only borrower collateral constraints suggest that just monetary policy should be used.
14
Limiting credit is
misguided and runs counter to the stimulus provided by monetary policy. Models with endogenous financial
distortions reach the opposite conclusions.
15
As lending by individual banks affects overall riskiness, it is optimal to
tighten macroprudential policy to rein in credit. But, the monetary policy response to inflation remains unchanged
from what is traditionally found. In practice, the appropriate policy mix will vary depending on both the strength
and expected persistence of the productivity shock, and the riskiness of balance sheets, including capital buffers
and leverage.
Similar considerations apply for an aggregate demand shock. A monetary policy response alone is optimal if it
durably stabilizes both inflation and output. When stabilizing inflation comes at the cost of lost output, and when
lending imposes a systemic risk externality, there is some scope for using macroprudential policy alongside
monetary policy so as to limit systemic risk stemming from the expansion in leverage.
12
Complications can arise when macroprudential policy is tightened in stressed conditions and monetary policy is
already constrained by its lower bound.
13
Some papers differentiate between capital requirements and LTV ratios (such as Angelini and others, 2011), but
most models remain too simple to properly distinguish among instruments.
14
As in Bailliu and others (2012), Beau and others (2012), Kannan and others (2009), Unsal (2011), Angelini and
others (2011), Bean and others (2010), and Cecchetti and Kohler (2012).
15
Christensen and others (2011) or modeling approaches as in Brunnermeier and Sannikov (2011), or Lambertini and
others (2011).
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26. Existing analytical methods support the conjecture that the conduct of both policies
does not change markedly compared to a world without side effects (Box 3). In particular, these
models suggest that the optimal calibration of the reaction of monetary policy to output and
inflation does not change markedly when macroprudential policy is also used, even when different
types of shocks are considered.
27. More generally, effective macroprudential and monetary policies can enhance each other.
Where a country has a credible monetary policy regime and inflationary expectations are well-anchored,
monetary policy responses to shocks need not be as aggressive, reducing the burden on
macroprudential policy to contain their side-effects (the background paper provides a case study on
emerging Europe).
16
Conversely, since there are now extra tools to deal with financial stability,
macroprudential policies can make the commitment of monetary policy to price stability more credible.
Moreover, effective macroprudential policies can help avoid financial stress, where accommodative and
unconventional monetary policy may be needed, and thereby reduce moral hazard.
28. The precise interaction between monetary and macroprudential policy will depend on
country-specific circumstances. For instance, where positive supply shocks reduce goods market
inflation but drive up asset prices and credit, macroprudential policy can deal with the latter,
allowing for a more accommodative monetary policy stance. In open economies, when capital
inflows lead to increased leverage and exposures to exchange rates, and macroprudential policies
contain these developments, monetary policy can afford to be tighter in response to inflationary
shocks. In both cases, macroprudential policies will tend to reduce trade-offs and increase room for
maneuver for monetary policy.
29. When other considerations are taken into account, however, the policy response may
need to be different, and coordination issues can arise. The conclusions drawn from the available
models relies on important simplifications, namely that the macroprudential instruments are
perfectly targeted, fully offset the financial shock or distortion, and are immune to time
inconsistency issues arising in part for reasons of political economy. While the presence of side
effects by itself does not pose significant challenges for the conduct of each policy, other
considerations can do so. Constraints on one policy may increase the burden on the other and
additional distortions and political economy factors can give rise to coordination issues. In the next
section, we analyze the implications of these additional complications.
16
The experience in emerging Europe over the previous decade underscores the benefits of credible monetary policy
frameworks for financial stability. The evidence suggests that lower policy rates reduced the incentive for unhedged
FX borrowing in some countries, relative to other emerging economies in the region (see background paper).
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III. EXPERIENCES AND LIMITATIONS
30. Imperfectly functioning macroprudential and monetary policies, and institutional and
political economy constraints imply a departure from the benchmark world described thus
far. Limited quantitative knowledge on the effects of macroprudential policies and of monetary
policy on financial stability makes it hard to design well-targeted macroprudential policies.
Constraints on monetary (and fiscal) policies may increase the role of macroprudential policies in
countercyclical management. Lastly, political economy and institutional constraints can generate
coordination issues.
17
This section reviews these complications, drawing on experiences, limited as
they are.
A. Imperfect Macroprudential Policies
31. Financial stability concerns are hard to capture in practice. For one, it is hard to
differentiate efficient market responses from those inefficient ones arising from market failures or
externalities. As such, it can be hard to determine when macroprudential policies need to be
employed, loosened, or tightened. Lower interest rates, for example, can lead to some increased risk
taking, but to a large degree this is desirable when monetary policy tries to support the real
economy. Related, measuring (increased) chances of financial instability has proven to be very
difficult, as reflected in the long-ongoing debate on whether policy makers can identify, let alone
prick, asset bubbles. Balancing Type I (too little emphasis on financial stability) with Type II errors
(too much control or too often “crying wolf”) is consequently also a challenge for macroprudential
policy applications.
32. Limited knowledge on the quantitative impact of macroprudential policies makes
calibration difficult. Designing macroprudential policies requires determining how large a buffer
should be built up during boom periods and when and how much it can be released safely during
periods of financial stress. However, experience still needs to be gained on how to best calibrate and
adjust macroprudential policy tools in the face of changing economic conditions, and quantitative
research faces a range of obstacles.
18
Some suggested macroprudential tools have never been tried
in practice. Another unknown is how different financial distortions and tools to address them
interact with each other. It may be the case that addressing one improves others, reducing the need
for multiple tools. It can also be the opposite, by mitigating one distortion, others are worsened,
increasing the need for multiple tools. Greater clarity is consequently needed on the exact
17
Other constraints naturally arise, such as the identification of permanent versus transitory shocks or the nature of
the shocks. These complications, however, are not different than those faced in other policy areas.
18
Many analyses suffer from endogeneity problems well-known to studies of effects of policy changes on aggregate
financial and real variables. This issue is shared by most existing studies on the effects of macroprudential policies
(Lim and others, 2011). However, when investigating real aggregate effects—which are the focus of work presented
in the background paper—this bias should be less since macroprudential policies ought to respond to credit and
asset prices, rather than to output. Moreover, if endogeneity does not differ across tools, it does not affect the
comparisons of relative effects.
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transmission and effectiveness of many macroprudential instruments, including on their interactions
among themselves (see also CGFS, 2012). Much of this work will be country specific in nature, and is
the subject of ongoing efforts by country authorities and Fund staff, in the context of surveillance
and technical assistance.
33. Existing models of monetary and macroprudential policy interactions not only lack a
description of the causes and onset of financial crises, but also assume that macroprudential
tools work perfectly. In reality, financial crises often arise from what appear to be small shocks,
which yet trigger large-scale financial turmoil. These phenomena, which involve many interacting
non-linearities, are not well captured in the current generation of monetary models, most of which
have essentially linear structures.
19
Moreover, in the available models, macroprudential instruments
are usually assumed to be fully effective in containing systemic risk. In reality, macroprudential
policies are not perfectly targeted and do not fully offset financial distortions and shocks.
34. Practical experience with the use of both monetary and macroprudential policies for
price and financial stability is still limited. While some countries have used both policies in
conjunction, few countries have done so with clearly articulated and communicated objectives.
Experiences from countries as diverse as Brazil, Israel, Korea, Poland, Sweden, Turkey and the United
States illustrate the challenges, but also suggest that well-targeted macroprudential policies can
complement monetary policy in achieving both price and financial stability (see the background
paper). In Brazil, for instance, monetary policy and macroprudential tools (such as capital and
reserve requirements) worked in tandem in the post crisis period (2010-11) to contain an
overheating of the economy and to rein in risks from rapid credit growth. Alternatively, in Korea
during the 2000s, house price swings were only weakly correlated with inflation, and risks were
addressed through sector- and region specific variation in LTV and DTI ratios, while the central bank
used its policy rate to achieve stability of overall output and inflation.
35. As experience is still to be gained, policymakers may misjudge the effect of
macroprudential policies on output, which may give rise to policy errors. For example,
policymakers may overestimate the extent to which reserve requirements dampen aggregate
demand and inflation, and may thus choose too small an interest rate response.
20
While policy errors
also arise in other areas (monetary policy, for example, is conducted under uncertainty about the
output gap), the limited experience thus far with macroprudential tools may imply a larger
probability of errors, at least initially.
19
Linear structures with some inertia are also common in monetary policy models, explaining in part why policy rates
are often adjusted in gradual fashions. Despite their limitations, these models provide a useful benchmark for the
introduction of less effective policies and of institutional and political economy constraints. Goodhart and others
(2012) is a good example of ongoing work to overcome some of these limitations.
20
Arguably, this may have happened in Turkey, where reserves requirements were increased, but the policy rate was
not raised in response to inflationary pressures (see background paper, Turkey case study).
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36. Institutional constraints may impede the optimal deployment of macroprudential
instruments. Effectiveness of macroprudential policy requires access to an appropriately broad
range of prudential tools. Institutional arrangements may, however, limit the ability to use some
tools (background paper, Turkey case study). Macroprudential policies can require, among others,
cooperation and coordination with microprudential supervisory agencies, which may be legally or
institutionally difficult. Accounting issues may arise and prevent full use of provisioning
requirements.
21
Participation of the fiscal authority may be needed (for example, for time-varying
levies or proper tax treatment of dynamic provisioning), also as it can facilitate changes in legislation
to expand the set of tools available to the macroprudential policymaker (IMF, 2011a). This may again
be easier said than done. Importantly, the macroprudential authority may not have the expertise and
information to identify the build-up of financial risks and thus not be able to adopt and calibrate
appropriately macroprudential tools.
37. Imperfect macroprudential policies may give rise to costs. Imperfectly targeted or
excessively tight macroprudential policies imply a binding constraint in the wrong place or at the
wrong time which may worsen distortions (Caballero and Krishnamurthy, 2004).
22
Tighter regulations
can also create stronger incentives for circumvention, with the risk of vulnerabilities building up
outside of the regulatory perimeter and policymakers’ sight.
38. Weaknesses in the application of macroprudential policies make it more likely that
monetary policy may need to respond to financial conditions. Indeed, in models where
macroprudential policy is absent or time invariant, but in the presence of financial sector distortions,
it is optimal for monetary policy to respond to financial conditions, in addition to the output gap
and deviations of inflation from target.
23
By extension, to reduce the effects of imperfectly targeted
or less effective macroprudential policy, it can be desirable for monetary policy to respond to
financial conditions and “lend a hand” in achieving financial stability (e.g., by “leaning” against the
credit cycle).
24
This means monitoring a broader range of financial indicators such as buoyant credit
growth, increasing leverage, and other financial indicators, and adapting policy horizons.
21
In Spain, for instance, there was a tension between the requirements of international financial reporting standards
and the use of dynamic provisioning.
22
In an analysis of the evolution of banking system vulnerabilities in relation to the use of macroprudential policies,
Claessens et al. (2012) find that some macroprudential policies can impose constraints that lead banks to adjust
perversely in times of financial downturns. This can also happen with microprudential policies, such as minimum
capital and liquidity requirements, which can exacerbate procyclicality of credit in undesirable ways. This can justify a
macroprudential overlay to microprudential policies. A forthcoming MCM paper will explore further the relationship
between microprudential and macroprudential policies (Osinski and others, 2012).
23
See, for example, Curdia and Woodford (2009), Carlstrom and Fuerst (2010), Christiano and others (2010),
Woodford (2011). Kannan and others (2009) as well as Christensen and others (2011) also find that optimal monetary
policy responds to credit when macroprudential policy is not available while Ciccarelli and others (2012) discuss the
use of unconventional and conventional monetary policy together.
24
Many central banks (and especially in countries that still lack effective macroprudential policies) seem to consider
financial market conditions in setting monetary policy (Munoz and Schmidt-Hebbel, 2012).
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39. The relative weight monetary policy should assign to financial stability is not well-
known. Although conflicts between price and financial stability are unlikely to emerge (Issing, 2003),
the economic (output) costs of using monetary policy for financial stability objectives can be large.
25
For example, cross-country evidence suggest that at a five-year horizon, a 100 basis point hike in the
policy rate would reduce annual house price appreciation by only 1 percentage point, compared to
a historical average annual increase of 5 percent (see Crowe and others, 2011, for details). But it
would also lead to a decline in GDP growth of 0.3 percentage points. The experience in Japan in the
late 1980’s and the United States in the late 1920s are often cited as examples of the economic costs
of using monetary policy to prick asset bubbles. More generally, the transmission of monetary policy
to financial stability outcomes is uncertain (Annex II). Nevertheless, monetary policy will have to be
used at times to some degree to compensate for the limitations of macroprudential policy.
40. In particular, monetary policy will often need to respond to financial turmoil.
Monetary policy may need to be loosened to counter deflationary pressures and at the same time
stabilize the financial system. In fact, because both ex-ante regulation and ex-post interventions can
carry costs, it can be desirable to have a combination of both (Jeanne and Korinek, 2012). Such ex-
post monetary policies need to be complemented by proper crisis management tools, including
lender of last resort, and resolution and restructuring policies.
B. Constraints on Monetary Policy
41. Where monetary policy is constrained, the demands on macroprudential policy will be
greater. Financial distortions can manifest themselves in the form of an inefficient composition of
output, including across member countries of a currency union. Similarly, in small open economies
with exchange rate pegs, the required monetary stance can give rise to excessively strong incentives
for risk-taking (see Box 4).
26
In such cases, macroprudential policies will need to address the adverse
side-effects of monetary policy on financial stability.
27
However, macroprudential policy should not
be overburdened and will need to be complemented by strong fiscal and structural policies.
28
And,
25
One example of a conflict could be when a country faces low goods price inflation and high asset price inflation, a
situation in several advanced economies before the 2008 crisis (see the background paper for a case study of the
United States).
26
See, among others, Cetorelli and Goldberg (2012) and Bruno and Shin (2012) on how global monetary conditions
can be transmitted through cross-border banking operations and affect risk-taking in small open economies.
27
For instance, loan-to-value ratios and capital buffers need to respond to asset bubbles and credit booms that may
arise at the national level, rather than at the level of the region. This is independent of whether the calibration powers
sit at the national level or at the center. The converse case, when tight international monetary policy conditions lead
to inefficiently low levels of risk-taking, could call for some relaxation of national macroprudential policies.
28
Credit booms and asset bubbles can be spurred by cross-border capital flows. The underlying external imbalances
need to be addressed by appropriate macroeconomic and structural policies, complemented by macroprudential
policies. National fiscal policy in a currency union has an important role to play in offsetting a monetary policy stance
at the union level that is not appropriate for a given country; and a union level fiscal policy will also in general be
needed. The euro area is a case in point (Jaumotte and others, forthcoming).
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especially in a currency union, macroprudential policies would ideally be coordinated, albeit not
necessarily harmonized, so as to recognize differences in financial conditions, across countries, as
recognized by members in the European Union in establishing the European Systemic Risk Board
(see also IMF, 2012b).
42. Where monetary policy lacks credibility or effectiveness, macroprudential policy
should not be used as a substitute. Where monetary arrangements are not adequate, there is
more to gain from strengthening monetary policy’s effectiveness, including the policy framework for
monetary policy, than from using macroprudential policies as imperfect substitutes. Adverse
financial developments can occur when monetary policy is lacking in effectiveness. While these
developments may be controlled by macroprudential policies, this will in turn create costly
distortions and greater incentives for circumvention. For instance, where a small open economy has
a peg that is very credible but not perfectly assured, this can create incentives for foreign currency
borrowing (Dell’Ariccia and others, 2012), and yet the macroprudential measures to effectively
contain this may be too costly.
Box 4. Monetary and Macroprudential Policies in Small Open Economies
In small open economies, capital flows are driven in part by differentials between domestic and global
policy rates (Hahm and others, 2012, background paper). Where high domestic rates fuel capital inflows,
this can drive credit growth, contribute to excessive leverage, and increase maturity and currency mismatches.
Many small open economies, such as Iceland and some Central, Eastern and South-Eastern European (CESEE)
economies, faced this dilemma before the crisis. And given low policy rates in advanced economies since the
crisis, a number of emerging economies (for example Brazil, Peru, and Turkey) are facing it today. For
countries with fixed exchange rates, low advanced country policy rates have created challenges, both ahead
of the crisis (for example, in the GCC countries, including Dubai), as well as more recently.
The dilemma arising from interactions between monetary policy and capital flows can be alleviated
by macroprudential measures. Targeted measures, such as the levy on non-core foreign exchange
liabilities in Korea (case study, background paper), may help change the composition of flows, thereby
reducing the financial stability risk associated with capital inflows. Where policy rate differentials encourage
corporations or households to borrow in foreign exchange, macroprudential measures, including higher risk
weights, tighter LTV ratios, and limits on foreign exchange lending, as applied in some CESEE economies
(case study, background paper), can limit increases in default risks. And a combination of increases in capital
and reserves requirements can help control surges in credit growth associated with capital flows, as in Brazil
(case study, background paper), complementing changes in policy rates and providing greater policy
autonomy.
Such use of macroprudential measures can be consistent with the IMF’s institutional view on
managing capital flows (IMF 2012b). This view specifically encourages targeted macroprudential
measures to contain the systemic risk associated with capital inflow surges. Indeed, a strong
macroprudential policy framework can help countries reap the benefits of capital mobility while mitigating
the potential costs.
C. Institutional and Political Economy Considerations
43. Institutional constraints can lead to complex coordination issues. A parallel with
monetary-fiscal interactions is useful. In those well-studied interactions, distortions introduced by
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44. fiscal policy (Dixit and Lambertini, 2003) or time-inconsistency problems stemming from
political factors (Barro and Gordon, 1983) generate coordination issues. Similar problems can arise
here. A microprudential regulator in charge of macroprudential policies may tighten regulation in a
recession. Or problems may arise when macroprudential policies do not work perfectly, for reasons
given in the previous section. In addition, different institutions can have different views of the
economy and the financial system (and sometimes fundamentally different views), which can lead to
ineffective policy coordination. As these coordination issues arise, they may imply different
outcomes under joint decision-making than under separation.
45. Political economy and other considerations may introduce further complications.
Political economy constraints are well understood in the case of monetary policy, leading to the
need for an independent central bank. They also arise for macroprudential policies. A
macroprudential regulator without sufficient political independence may be reluctant to constrain
credit (for example, since this may be politically unpopular and also reduces tax revenues in the
short run) even if that is the socially optimal policy.
29
And the frequency with which macroprudential
policy may be used can be less than ideal owing to political and other constraints, as when broad
approval is required to reset an instrument, or when use of the instrument has strong distributional
implications.
30
In light of these and other constraints, monetary policy will again retain a residual
role in assuring financial stability.
46. There is thus a need for a strong legal mandate and appropriate powers, dedicated
decision-making, accountability, and communication tools. As is recognized in other areas of
policymaking, the legal framework needs to allow the policymaker to set out a policy strategy,
establish transparency on the deliberations leading to decisions, and provide for ultimate
accountability to legislators and the public at large (IMF 2012a). These conditions are important to
achieving effective policy implementation.
47. There is also a need for strong coordination between monetary and macroprudential
policies. To maximize synergies, mechanisms that facilitate policy coordination are desirable, such
as decision-making supported by shared information and analysis, but these should not undermine
the credibility of each policy field in achieving its primary objective, and need importantly to
preserve the independence of monetary policy decisions (see further Nier and others, 2011).
31
29
These risks may be greater when the fiscal authority assumes a leading role in the macroprudential framework.
However participation of the fiscal authorities is in general desirable, since it can facilitate discussion of legislative
changes that may be needed to adapt the regulatory perimeter and to establish new macroprudential policy tools
and powers in the face of changing circumstances (Nier and others, 2011).
30
In the United Kingdom, the Financial Policy Committee did not ask for control over loan-to-value ratios, since this
tool was viewed as having strong distributional effects.
31
The experience in Turkey in early 2011 highlights the need for coordination between the central bank and the
supervisory authority (background paper). There is also a need for a communications policy that provides clarity for
market participants and the public at large on the objectives and actions of policymakers.
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48. The precise coordination mechanisms will depend on country circumstances, but will
often entail a leading role in macroprudential policy for the central bank. This has some key
advantages. It can ensure that macroprudential policy draws on the central bank’s expertise in
financial and macroeconomic analyses, that data and analyses prepared for each policy field are also
available to the other, and facilitate analyses of the side effects of each policy. Furthermore, it can
help shield the macroprudential policy function more from political influence than when it is
assigned to a separate regulatory body. It also has risks though. A central bank formally responsible
for both price and financial stability could be tempted to use inflation to repair private balance
sheets following a financial shock, leading to a welfare loss (Ueda and Valencia, 2012). With such
time-consistency as well as other conflicts, a dual mandate can be associated with lower credibility
and create reputational risks. And it poses challenges for communication that could imply a loss in
the transparency of monetary policy.
32
49. When both monetary and macroprudential functions are housed within the central
bank, coordination is improved but safeguards are needed to counter the risks from assigning
dual objectives to the central bank. These should include separate decision-making structures for
monetary and macroprudential policies (such as separate policy committees as in the United
Kingdom). Separate accountability and communications structures are also advisable (such as
separate reports to the legislature). It is often the case that these issues are best addressed in
legislation, by establishing in law a central bank’s governance structure and clarifying the primary
objectives of each policy function. These issues will be addressed in upcoming staff papers.
50. A different set of issues arises when the macroprudential policy function is outside the
central bank. Where the macroprudential authority is assigned to a body or committee outside the
central bank, it is still useful, and possible, for the central bank to play a leading role. For example,
chairmanship of the committee can be assigned to the central bank. However, in some countries,
there may be conflicts with provisions to protect the independence of the central bank, which may
be enshrined in the constitution. Constitutional constraints may limit the central bank’s ability to
participate in a macroprudential committee, for example when this committee is chaired by the
Treasury, rather than by the central bank.
33
Also, constitutional considerations may rule out any
formal powers of the macroprudential body over policy tools typically assigned to the central bank,
such as reserve requirements, oversight of payment and settlement systems, and regulation of
foreign exchange markets (as in Poland, see IMF, 2012a). And when the central bank conducts
microprudential supervision, the macroprudential body may not be able recommend use of
32
Giavazzi and Mishkin (2006) conducted interviews with participants from different sectors of Swedish society and
found that statements on house prices by the Riksbank confused the public. Also, in a number of small open
economies, reserve requirements are used with both monetary policy and macroprudential policies objectives
(Federico and others, 2012; and Tovar and others, 2012), raising communication challenges. See also the case study
on Turkey in the background paper.
33
For instance, in Chile, the central bank has only an observer status on a financial stability committee chaired by the
Treasury (Jacome and others, 2012).
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supervisory tools (as under current proposals in the Netherlands). These issues could constrain
coordination and limit the effectiveness of macroprudential policies.
51. Interactions with other policies may give rise to additional coordination issues that
may need to be reflected in the institutional framework. Macroprudential and microprudential
policies could at times conflict, and the way these conflicts are resolved may differ depending on
whether microprudential supervision is housed within or outside the central bank. Similarly, the
boundary between macroprudential policies and crisis management raises coordination issues. And
a need for coordination with the fiscal authority can also arise. A discussion of these additional
challenges is planned for future work (including the upcoming Board paper on “Key Aspects of
Macroprudential Policy”).
IV. CONCLUSIONS
52. The crisis has accelerated the development of macroprudential policy, raising
questions about how it interacts with monetary policy. The emerging paradigm acknowledges
that monetary policy is not well suited for assuring financial stability. Instead macroprudential tools
should aim to address financial distortions that may lead to a build-up of systemic risk. The new
paradigm recognizes that well-calibrated and clearly communicated macroprudential policies can
contain risks ex-ante and help buffer shocks, and thereby ease the conduct of monetary policy
during periods of financial stress. It does acknowledge, however, that monetary policy can have
effects on financial stability. However, in a world where each policy operates perfectly in attaining its
objective, these side effects do not pose significant challenges to the conduct of both policies.
53. When policies do not operate perfectly, the interactions between them become
important. The effectiveness of macroprudential policies and the interactions between
macroprudential and monetary policies are not fully known, institutions are imperfect, and political
economy and other constraints can arise. With weaknesses in the application of macroprudential
policies, monetary policy may still need to respond to the buildup of financial risk, by “leaning”
against the credit cycle, and, at times, be expansionary following negative financial shocks.
Conversely, where monetary policy at the national level is constrained, as in currency unions, there
will be greater demands on macroprudential policy, coordinated across countries. There are few
cases though in which a substitution of macroprudential policies for weak monetary policy is
optimal.
54. The new paradigm calls for an appropriate institutional framework, and especially for
safeguards when there are dual objectives assigned to one agency. The presence of
macroprudential policy can enhance monetary policy’s credibility and transparency, since there now
is an additional tool to deal with financial stability. A credible monetary policy framework in turn can
help macroprudential policy in achieving its objective, by reducing the need for macroprudential
policy to contain adverse effects of monetary policy on financial stability. When there are synergies,
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it can be advantageous to assign both policies to the same authority, namely the central bank.
However, safeguards are then needed to counter the risks of dual objectives assigned to one
agency, and institutional frameworks should distinguish between the two policy functions, with
separate decision-making, accountability and communication structures. A different set of issues
arises when the macroprudential policy function is established outside of the central bank.
55. This paper has highlighted the many issues on which more work is needed to arrive at
robust policy recommendations. Knowledge on the effectiveness of macroprudential policies does
not yet compare with that on monetary policy, limiting what can be known about the interactions
between the two policies. Further work is needed on how macroprudential policies can be
operationalized and on understanding the transmission of macroprudential policies, both in upturns
and in downturns. The interaction with other policies, including microprudential, crisis management
and fiscal policies also requires further work.
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2
3
3
-8
-6
-4
-2
0
2
4
6
8
2000 2002 2004 2006 2008 2010
Output Gap
(In percent of Potential Output)
W.E.O. September, 2007
Ireland Spain United States
-4
-2
0
2
4
6
2001Q1 2004Q1 2007Q1 2010Q1
Headline Inflation
(In percent)
Ireland Spain United States
Annex I. Price, Output, and Financial Stability
1. With monetary policy focused primarily on price stability, systemic financial risks were
largely unaddressed during the Great Moderation. Pre-crisis estimates of the output gap for key
countries that subsequently experienced a crisis (Ireland, Spain, United States) were relatively flat
(Figure A1. Meanwhile, inflation was stable or only moderately rising. The prevailing monetary policy
paradigm thus delivered output and price stability.
Annex Figure 1. Output Gap Estimates, Headline Inflation, House Price, and Proportion of
Construction Components
Source: World Economic Outlook and Haver Analytics
2. Credit and asset prices were rapidly increasing, however, and price stability was not
sufficient to ensure continued macroeconomic stability. Distortions led to an inefficient
composition of output, with excessive real estate investment, excessive consumption, and widening
external imbalances (Figure A1 shows changes in asset prices and the composition of output). When
90
140
190
240
290
2000Q1 2002Q3 2005Q1 2007Q3 2010Q1
Residential Real Estate Prices,
2000Q1=100
Ireland Spain United States
40
60
80
100
120
140
160
180
2000 2002 2004 2006 2008 2010
Construction/Non-construction
components, 2000=100
Ireland Spain United States
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systemic risk materialized, the externalities arising from financial market imperfections intensified
and output declined, exacerbating macroeconomic volatility.
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2
2
5
5
Annex II. Literature on Channels through Which Monetary
Policy Can Affect Financial Stability
1. Borrower balance sheet (default) channel. Monetary policy can worsen financial stability
by affecting borrowing constraints and increasing the risk of default. First, tighter policy increases
debt repayment burdens for variable rate borrowers. Second, by affecting economic activity, it
reduces income flows and loan repayment capacity. Third, increases in rates lower borrower net
worth through a fall in asset prices, curtailing access to credit. Tighter policy then results in higher
default rates, lower banking profits, and larger non-performing loans. All of these may culminate in
a financial crisis (Allen and Gale, 2000; Illing, 2007, Goodhart and others, 2009). Jiménez et al (2009),
using micro data from the Spanish Credit Register for 1984–2006, find that interest rate increases
have strong effects on borrower default rates and the quality of banks’ portfolios. When debt is
securitized, increases in default rates can cause asset prices to fall, potentially leading to distress
sales and amplifying the initial fall (Shin, 2005; Illing, 2007; Geanakoplos, 2010). Sengupta (2010)
shows that tighter monetary policy in the United States after 2004 increased the debt service burden
on adjustable rate mortgages, leading to a sharp rise in defaults of Alt-A mortgage loans in 2006.
2. Risk-taking channel. Accommodative monetary policy can affect intermediaries’ incentives
to take risk. When interest rates are low, banks’ capital and collateral values are boosted. This can
lead intermediaries to expand their balance sheets, increase leverage, and reduce efforts in
screening borrowers (Borio and Zhu, 2008; Valencia, 2011; Dell’Ariccia and others, 2010). Such
incentives may be stronger when low interest rates reduce the likelihood of borrower defaults,
leading measured risks to go down and risk-weighted capital to go up (Adrian and Shin, 2012). They
may also be stronger when there are expectations for interest rates to be reduced aggressively when
a crisis erupts (Farhi and Tirole, 2012). Some studies find evidence for these effects when using loan
level data, e.g., Jiménez and others 2009; Ioannidou and others (2009), or survey data (Maddaloni
and Peydro, 2011). At more aggregate levels, studies typically do not find strong effects of rates on
risk-taking, leverage, or credit growth (Merrouche and Nier, 2010; Dell’Ariccia and others, 2012).
3. Risk-shifting channel. Increases in policy rates can reduce intermediation margins and lead
lenders to seek more risk. Bhattacharya (1982) shows that for highly levered institutions, the smaller
the intermediation margins, the riskier the assets they choose (when the choice of riskiness is
unobservable). An increase in policy rates tends to reduce the margins of intermediaries that are
funded short-term at variable rates, but lend long-term at fixed rates. Lower margins can induce a
move into riskier assets and toward higher leverage to maintain return on equity, thereby “shifting”
value from depositors and creditors to bank shareholders. This channel may be strongest just ahead
of a crisis, when intermediary leverage is high and competition limits the pass-through of policy
rates to loan rates. For the United States Savings and Loans crisis, Gan (2004) shows that interest
rate increases led mortgage lenders to shift into riskier securities. Landier and others (2011) also find
risk-shifting ahead of the United States subprime crisis.
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4. Asset price channel. When monetary policy is eased, lenders’ asset value and borrowers’
net worth increase. In response, the supply of and demand for loans increase. This leads to further
increases in asset prices through a “financial accelerator” mechanism (Bernanke and Gertler, 1989,
1995). Evidence is mixed, however, on whether low rates cause asset price booms and the effects, if
any, are often found to be quite small. Del Negro and Otrok (2007) find the impact of
accommodative policy to be small relative to the overall increase in house prices in the
United States. IMF (2009) finds that while in many advanced economies, rates had been low by
historical standards, there was little association between measures of the monetary policy stance
and house price increases. Whereas Ireland and Spain had low real short-term rates and large house
price rises, Australia, New Zealand, and the United Kingdom had relatively high real rates but also
large house price rises.
5. Exchange rate channel. In an open economy, monetary policy can affect the exchange rate
and capital flows. There is strong evidence that policy rate differentials attract capital flows, through
carry trades, in emerging markets and small open economies more generally (Hahm and others,
2012; Merrouche and Nier, 2010). In bank-based systems, capital inflows can in turn drive credit
growth and, owing to the presence of exchange rate externalities, contribute to excessive increases
in leverage. This poses a well-known dilemma, where raising domestic interest rates may induce
excessive capital inflows and credit growth. Given low policy rates in advanced economies, a number
of emerging economies (e.g., Brazil, Peru, and Turkey) have been struggling with these problems.
However, this channel was also relevant ahead of the crisis. In Iceland, high interest rate differentials
fueled capital inflows via the banking sector and a sharp appreciation and overheating of the
economy. As the inflation targeting central bank raised policy rates in response, it attracted even
more capital inflows, generating an adverse feedback loop (Jonsson, 2009). Many Central and
Eastern European economies also faced this dilemma before the crisis (background paper).
6. The table overleaf shows, for each channel, what theory predicts for the effects of
changes in the monetary policy stance on financial stability, and summarizes related empirical
evidence.
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7
7
Annex Table 1. Monetary Policy Effects on Financial Stability
1/
Sources of
Financial
Instability
Channel
Predicted Effect
( improves stability) Selected Empirical Evidence
↓r ↑r
Borrowing
Constraints
Balance Sheet
(default)
Channel
Sengupta (2010)
Jiménez and others (2009)
Gertler and Gilchrist (1994)
Asea and Blomberg (1998)
↑r ,
↑r ,
↑r ,
↑r ,
Risky
Behavior of
Financial
Institutions
Risk-taking
Channel
Jiménez and others (2009)
Ioannidou and others (2009)
Merrouche and Nier (2010)
↓r ,
↓r ,
X
Risk-shifting
Channel
Gan (2004)
Landier and others (2011)
↑r ,
↑r ,
Externalities
through
Aggregate
Prices
Asset price
Channel
Altunbas and others (2012)
Del Negro and Otrok (2007)
IMF (2009)
↓r ,
↓r ,
X
Exchange rate
Channel
Hahm and others (2012)
Merrouche and Nier (2010)
Jonsson (2009)
↑r ,
↑r ,
↑r ,
Source: IMF
Notes: r means a↓ decrease of policy rates, r means a↑ n increase of policy rates, “ ” means a decline
instability, “ ” an improvement, and “X” no statistically significant effect.
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