Working Paper: CEPR ID: DP13530
Authors: David Martinez-Miera; Rafael Repullo
Abstract: This paper reexamines from a theoretical perspective the role of monetary and macroprudential policies in addressing the build-up of risks in the financial system. We construct a stylized general equilibrium model in which the key friction comes from a moral hazard problem in firms' financing that banks' equity capital serves to ameliorate. Tight monetary policy is introduced by open market sales of government debt, and tight macroprudential policy by an increase in capital requirements. We show that both policies are useful, but macroprudential policy is more effective in terms of financial stability and leads to higher social welfare.
Keywords: bank monitoring; intermediation margin; monetary policy; macroprudential policy; capital requirements; financial stability
JEL Codes: G21; G28; E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tight monetary policy (E52) | increased returns on debt and equity (G12) |
| Tight monetary policy (E52) | reduces investment for both safe and risky entrepreneurs (G31) |
| Tight monetary policy (E52) | increases the intermediation margin (G21) |
| Tight monetary policy (E52) | reduces banks' risk-taking (G21) |
| Increase in capital requirements (G28) | raises the return on equity (G32) |
| Increase in capital requirements (G28) | decreases the return on debt (G32) |
| Increase in capital requirements (G28) | shifts investment from risky to safe firms (G11) |
| Increase in capital requirements (G28) | reduces banks' risk-taking (G21) |
| Tighter monetary policy (when capital requirements are binding) (E52) | increases banks' risk-taking (G21) |
| Macroprudential policy (E60) | more effective than monetary policy for reducing risk-taking by banks (G21) |
| Increase in investors' wealth (G19) | higher investment from both safe and risky entrepreneurs (L26) |
| Increase in bankers' wealth (F65) | lower risk-taking by banks (G21) |
| Tighter monetary policy (E52) | increases banks' risk-taking (G21) |