MONETARY POLICY

Master 1
Pr Jean-christophe Poutineau
University of Rennes 1- France
 Chapter 4
New challenges 1:
financial frictions
Introduction:
• 10 years after 2007

• The financial crisis has deeply affected central bank decisions

• Account for the financial cycle and financial frictions

• New policy tool: macroprudential policy

• Unconventional policy at the ZLB

• Quantitative easing
• Forward guidance
Introduction:
the role of financial factors and Macroprudential
Policy
• Monetary policy during the great moderation ignored financial factors

• The financial crisis has deeply modified the landscape

• Should the central bank policy take into account financial fluctuations

• Or develop a new policy ? (macroprudential policy)

Roadmap

• How financial factors affect the transmission of shocks ?

• The role of the financial accelerator

• Redifining the policy landscape

• Needs a specialisation of the central bank ?
• Needs an extended mandate for the central bank ?
Financial aspects of the macroeconomy
• The financial turmoil of 2007 has significantly affected the landscape
of short run macroeconomics.

• This episode has reassessed the amplifying role of financial factors in

economic fluctuations.

• On the policy side, it has induced new practices in the conduct of

monetary policy such as the adoption of unconventional measures.

• Furthermore, it has led economists to evaluate new policy practices

regarding the way risks associated to financial decisions should be
controlled to dampen output fluctuations.
• This episode has broken a general agreement limiting financial
supervision at the micro level
• A new consensus has emerged, considering that prudential measures
should also be set at the aggregate level through macroprudential
measures.
• the final objective of macroprudential policy
• is to prevent or mitigate systemic risks that arise from developments within
the financial system,
• taking into account macroeconomic developments, so as to avoid periods of
widespread distress.

• The novel dimension introduced by macroprudential policy is to

promote the stability of the financial system in a global sense, not just
focusing on individual financial intermediaries.
• This aggregate approach aims at solving a fallacy of composition in
the evaluation of financial distress.
• A simple example makes this fallacy easy to understand:
• it is rational for a bank to sell assets with a decreasing value to mitigate the
risk at the individual level.
• However, generalizing this decision at the aggregate level is not optimal for
the economy as a whole since it leads to a higher decrease in the price of this
asset thus amplifying financial troubles.
• The definition of macroprudential measures is thus necessary to avoid this
kind of problem.
I - THE EFFECT OF FINANCIAL FRICTIONS IN THE
CASE OF A SIMPLE MONETARY POLICY RULE
• The financial developments of credit in the US economy move in line
with activity.
• In particular during the recent financial crisis, it is easy to see how the
credit crunch is in line with contraction of US output.
• the procyclicality of financial decisions and the consequences of this
phenomenon in the transmission of demand and supply shocks.
• The model
• The Phillips curve is standard.
• In the new Keynesian Phillips Curve () is the rate of inflation, is the
output gap and is a cost-push shock on the supply side (a positive
realization of this shock describes an exogenous increase in goods
prices).
• We assume that monetary policy is credible (so that, inflation
expectations are based on the targeted inflation rate, , as in Bofinger
et al. (2006)).
• Parameter is the elasticity of inflation to the output gap.
• Regarding monetary policy (), authorities control the policy relevant
interest rate,, according to a Taylor rule. Here, is the elasticity of the
interest rate to the output gap, is the elasticity of the interest rate to
the inflation rate and is the natural interest rate.
• The curve is affected by financial frictions.
• We account for the fact that some agents (such as big firms) can issue
bonds to finance their investment, while others (small firms or
households) are credit constrained and must borrow from the
banking system.
• The simplest solution for the possibility of banks having an impact on
the level of activity (though the fraction of aggregate investment
projects financed with loans) is to follow Bernanke and Blinder (1989)
and to distinguish two interest rates in the curve.
• The lending rate () is determined by the equilibrium in the lending
market while the short run interest rate on bonds () is set by the
monetary authority
• Thus agents that borrow from banks to finance their investment are
faced with an interest rate that differs from the interest rate set by
monetary authorities.
• Finally, is natural interest rate (so that in the absence of shocks and
financial frictions, the output gap is zero and ), is a demand shock, is
the elasticity of the output gap to the policy oriented interest rate and is
the elasticity of the output gap to the interest rate on bank loans.
• We go back to the standard IS curve if
• The last equation of the model () explains the determination of the
interest rate for private sector loans.

• This relation provides a simple channel to account for the

procyclicality of financial factors.

• According to this relation, the external finance premium is

countercyclical as a positive output gap reduces the interest rate
spread. The microfoundation of this relation is provided in appendix.
• The micro foundation of FA: have a look at loan supply and demand
• Interest rate
• The last equation of the model () explains the determination of the
interest rate for private sector loans.
• This relation provides a simple channel to account for the
procyclicality of financial factors.
• The external finance premium is countercyclical as a positive output
gap reduces the interest rate spread.
• The microfoundation of this relation is provided in appendix.
• The financial accelerator operates as follows:
• as a positive output gap increases income in the economy loans are
more likely to be repaid, leading to a reduction in the risk premium.
• By relaxing the interest rate spread, it leads to more investment, that
in turn implies a further increase in the output gap.
• This financial friction increases macroeconomic volatility
• To get a clear understanding of the realization of the macroeconomic
equilibrium, we focus on three main “gaps”:
• the output gap (i.e., the difference between actual and full employment
output),
• the inflation gap (i.e., the difference between the actual and the targeted
inflation rate)
• the interest rate spread (i.e., the difference between the interest rate on
bank loans and the interest rate of the central bank).
• The model (1)-(4) can be solved sequentially to evaluate the effect of
financial frictions on key relations such as the and curves.

• First, combining the and relations, we get the financially constrained -

relation,

• The standard expression of the schedule is obtained when disabling

credit frictions (i.e. imposing in the previous expression).

• Financial frictions affect

• the slope of the curve
• the impact of demand shocks on the situation of this schedule in the () space.
• Second, combining the constrained - curve (2) with the Taylor rule (3),
we get the Aggregate Demand schedule that accounts for the Banking
system ()as,

(5)

• The standard expression of the Aggregate Demand () schedule is

obtained without financial frictions (i.e. imposing in the previous
expression).
• The equilibrium of the model that solves the - system is,
• The consequences of financial frictions on the diffusion of supply ()
and demand () shocks are reported in Table 1.
• As observed, in the case of procyclicality of financial factors (namely
when ), supply and demand shocks amplify the variation of the output
gap.

• In contrast, the inflationary consequences of the supply shocks are

dampened with financial frictions.
• An inflation cost
• a positive cost push shock () moves the schedule upwards.

• As a negative supply shock, it leads to a negative output gap and an

increase in inflation.

• The procyclicality of financial factors amplifies the negative impact of

the shock as this tends to increase the interest rate gap in the
economy and, as a by-product, implies a higher decrease in the
output gap as ().

• In the meanwhile, as the procyclicality of financial factors reduces

more aggregate demand in the economy, the cost-push shock leads to
less inflation ().
• A demand shock
• a positive demand shock () moves the schedule rightward further than the
baseline curve, as .

• For an unchanged schedule, this amplifies both the output and the inflation
gaps.

• Indeed, the procyclicality of financial factors amplifies the positive impact of

the shock as this tends to decrease the interest rate gap in the economy:

• by improving the solvability of borrowers, a higher output gap leads banks

to decrease the interest rates on private loans.

• This implies a further increase in the output gap (), which in turn has a
higher impact on the inflation rate ().
• the procyclicality of the financial sector leads to higher fluctuations in
the output gap.

• how authorities should react to the building of financial imbalances ?

• This problem is traditionally analyzed in the context of the choice of

an optimal monetary policy.

• The sensitivity of the interest rate reaction to shocks is thus

determined endogenously, depending on the objective(s) of the
policy.
II - Optimal Policy

• 3 cases
• MoPo without financial concern
• MoPo with financial concern
• combine Monetary and Macrocroprudential policies
A – Mo Po without a Financial Stability
Concern
• In the standard analysis of optimal monetary policy, the interest rate
is chosen by the authorities to minimize a quadratic loss function ()
expressed in terms of the output gap,, and the inflation gap ,
(6)
• subject to the supply constraint (equation (1)) of the private sector.
• In this expression, represents the weight imposed on inflation rate
deviations with respect to the full employment target.
• The first order conditions that solve this problem can be combined to
get the targeting rule as,

(7)

• This targeting rule defines the desired balance that the central bank
wants to reach between full employment and price stabilization.

• It accounts for both society’s inflation reluctance () and the elasticity

of the inflation rate to the output gap in the Phillips curve ().
• The marginal rate of substitution between inflation and the output
gap (a sort of “sacrifice ratio”) is determined by,

• so the central bank accepts a higher increase in inflation () following a

reduction in the output gap ()
• when the weight associated to the objective of price stability is lower ()
• or for a lower elasticity of the inflation rate with respect to the output gap ().
• The solution of the optimal monetary policy is summarized in Table 2.
As observed, we get a new version of the “divine coincidence” that
also applies to the interest rate differential. An extensive presentation
of this situation is proposed by Bofinger et al. (2006).
• Namely, acting optimally (i.e., setting the best value for the interest rate),
the monetary authorities are able to close the output gap following a
demand shock.

• Acting so, they reach the inflation target and there is no effect of the
demand shock on the output and interest rate gaps. To support this
equilibrium monetary authorities must set their interest rate as,

• 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.
B – Mo Po with a Financial Stability
Concern
• Monetary authorities may also adjust the short term interest rate in an
effort to reduce the building of financial imbalances. In this case, the
authorities’ loss function () should be extended to account for the spread
between the lending and the policy oriented interest rates, as proposed by
Cecchetti and Kohler (2012),

• In this expression, the relative weight regarding the inflation gap () and the
interest rate spread () are expressed with respect to the full employment
target.
As the authorities are now making an arbitrage between three main
concerns, they minimize this function,

• subject to the Phillips curve (equation (1))

• and the financial accelerator (equation (4))

•
• Combining the three first order conditions that solve this minimization
program, we now get a targeting rule that combines the three policy
concerns as,

• Combining this expression with the Financial accelerator (), the marginal rate
of substitution between inflation and the output gap is now given as,

If the central bank interest rate decision accounts for financial stability as well
as price stability, it should accept a higher increase in inflation following a
reduction in the output gap.
• The divine coincidence is still observed at the general equilibrium of
the model

• the picture is a bit different regarding the impact of a cost push shock.

• As observed, the introduction of financial stability concerns in the

definition of an optimal monetary policy affects the macroeconomic
outcome, as:
• it clearly stabilizes both the output and interest rate gaps,
• it deteriorates price stability.
• extending the mandate of monetary policy to stabilize the interest rate spread
leads to a smaller increase in the interest rate in case of supply shocks.
• As monetary policy is less restrictive, inflation is higher while the interest rate
spread is lower.
• Targeting financial stability as a supplementary objective of monetary
policy defined in terms of an optimal interest rate rule deteriorates
price stability.

• This result illustrates the problem of a missing instrument to achieve a

supplementary goal.

• As already underlined by Tinbergen (1952), one further (linearly

independent) policy target requires one further (linearly independent)
instrument.

• Thus, macroprudential policy can be introduced as a simple solution

to this missing instrument problem.
• The management of financial stability as an supplementary concern of
monetary policy is a debated question.

• The introduction of an additional macroeconomic policy instrument

aimed at mitigating financial imbalances appears as a natural solution
to solve the Tinbergen problem outlined in the previous subsection.
• We introduce macroprudential concerns using bank capital
requirements as an instrument

• We follow Cecchetti and Kohler (2012) by assuming that the

instrument set by the relevant authorities is related to bank capital
requirements ().
• The introduction of macroprudential measures affects the structure of the
relation.

• assuming that the instrument set by the relevant authorities is related to bank
capital requirements ().

• As the main problem stems from the procyclicality of financial decisions. This
macroprudential instrument moderates the financial cycle, as it constrains the
increase of loans in good times, while it dampens the reduction of loans in bad
times.

• The aggregate supply of loans now writes,

• where parameter measures the sensitivity of loans supplied by the consolidated

banking system to capital requirements .
• Solving the equilibrium condition of the loan market () for the value of
the lending rate , with a complete interest rate pass-through, this new
instrument affects the financial accelerator () as it drives a wedge
between the interest rate spread () and the output gap (),

• where is the elasticity of the interest rate gap to the bank capital
requirement.
• In this expression, is the elasticity of the interest rate gap to the bank capital
requirement: it is equal to the ratio between the sensitivity of the loan supply to
this instrument and the elasticity of loan demand to the lending interest rate.

• In this situation, the authorities in charge of financial stability can control the
interest rate spread with their own policy instrument, .

• As a consequence, the interest rate can be used conventionally by the central

bank to stabilize prices in the economy.

• As an example, if the banking system issues too much loans with respect to the
macroeconomic performance of the economy, a rise in the value of , by increasing
the interest rate paid on loans, may reduce the incentives to borrow. It thus
reduces the incentive for risk taking and builds up buffers ex-ante to avoid a
financial crisis.
• Interest rate spread
• The loss function of the central bank is

• The loss function of the macroprudential agency is

• The two policy instruments (namely and ) cannot be set
independently.

• First, concentrating on the relation, ceteris paribus (for a given output

gap), an increase in the interest rate leads to a reduction of the
interest rate spread which may affect the value of set by the
macroprudential authorities.

• Second, the bank capital requirement affects the interest rate spread,
and thereby the output gap, which in turn affects the interest rate .
• Thus, we assume perfect coordination in the setting of the policy
instruments
• targeting rule of the joint authority is now defined as,

• The equilibrium solution of the model is obtained by finding five

variables with only four equations.

• The only possibility to get a solution in this situation is to proceed

sequentially as follows: the cooperative situation allows the joint
authority to close the interest rate spread ( in equation (8)), so that
the macroprudential instrument should be set according to,
•
• This result illustrates the Mundellian Policy Assignment principle: in
the cooperative equilibrium, capital requirements should be
specialized to address the procyclicality problem.

• This instrument must be set (proportionally to the elasticity ) with

respect to the fluctuations in the output gap.
• In this case, the targeting rule of the authorities degenerates to,

• so that with macroprudential policy, the marginal rate of substitution

between inflation and the output is,
•
• with macroprudential policy, the marginal rate of substitution
between inflation and the output is,

• Even if this value is higher to the original monetary policy solution, it

may lead to better results than the extended monetary policy on
inflation if .
• This condition is met for a high procyclicality of financial decisions ()
and a high reluctance of the society with respect to financial stress ().
• The reduced form of the macroeconomic equilibrium reached with
macroprudential policy is reported in the third column of Table 2.
• This equilibrium requires the policy stance to be defined as follows,
•
•
• Solution of the problem
• As reported in Table 2 the distribution of “gaps” in the economy is
affected by the choice between an extended monetary policy
accounting for financial stress and the introduction of
macroprudential decisions.
• More particularly, the combination of a standard monetary policy
with a macroprudential policy leads to better results in terms of
inflation and interest gaps than the extended monetary policy
situation.
• Thus, introducing a macroprudential instrument in the conduct of
macroeconomic policy may restore more efficiency regarding price
stability with a very good results on financial imbalances.

• However, as monetary policy is more reactive to inflation

developments, it has a relatively more negative impact on activity
• The interest of the macroprudential solution may be assessed by
contrasting the welfare loss in the economy. Consolidating the
reduced form of the three “gaps” and the loss functions, we get,
•

• for the extended monetary policy, and,

•
• for the implementation of macroprudential measures with a standard
monetary rule.
• As observed, the final ranking between the two institutional
arrangements partly depends on the procyclicality of financial
decisions, as a higher value of by increasing with respect to makes
the implementation of macroprudential measures more interesting to
dampen financial imbalances.

• Following the Mundellian Policy Assignment principle,

macroprudential policy focuses on the procyclicality problem.
• Remarkably, the optimality of the cooperative solution also increases
with the society reluctance parameters regarding both price () and
financial () instability.

• As previously shown, using macroprudential policy to close the

interest rate spread leads to better results in terms of price stability.

• Accordingly, it suppresses welfare losses associated with the building

of financial imbalances. Thus, the gap distribution reached with
macroprudential policy leads to a higher welfare in the economy.
Conclusion
• The implementation of macroprudential measures is becoming a
generalized practice in developed economies to prevent the building
of financial imbalances such as the ones that led to the crisis of 2007-
2009.
• We used a simple static new Keynesian model extended to account
for financial frictions.
• We analyzed the destabilizing nature of financial frictions in the
transmission of real shocks and we discussed how a policymaker, who
is concerned about financial stability, would use macroprudential
policy tools as a complement to monetary policy measures.
• We show that combining a standard monetary policy with
macroprudential measures should be preferred to an extended
monetary policy when financial decisions are highly procyclicality
and/or a the society is highly reluctant to financial stress and inflation.
• This relation provides a simple channel to account for the
procyclicality of financial factors and the possibility to conduct
preventive macroprudential measures.
• In this situation, the authorities in charge of financial stability can
control the interest rate spread with their own policy instrument, .
• As a consequence, the interest rate can be used conventionally by
the central bank to stabilize prices in the economy.
• As an example, if the banking system issues too much loans with
respect to the macroeconomic performance of the economy, a rise in
the value of , by increasing the interest rate paid on loans, may reduce
the incentives to borrow.
• It thus reduces the incentive for risk taking and builds up buffers ex-
ante to avoid a financial crisis.