Working Paper: NBER ID: w11830
Authors: Stephen G. Cecchetti; Lianfa Li
Abstract: Central bankers and financial supervisors often have different goals. While monetary policymakers want to ensure that there are always sufficient lending activities to maintain high and stable economic growth, supervisors work to limit banks. lending capacities in order to prevent excessive risk-taking. To avoid working at cross-purposes, central bankers need to adopt a policy strategy that accounts for the impact of capital adequacy requirements. In this paper we derive an optimal monetary policy that reinforces prudential capital requirements at the same time that it stabilizes aggregate economic activity. We go on to show that policymakers at the Federal Reserve adjust interest rate policy in a way that would neutralize the procyclical impact of bank capital requirements. By contrast, central bankers in Germany and Japan clearly do not act as the theory suggests they should.
Keywords: Capital Adequacy; Monetary Policy; Economic Stability
JEL Codes: E52; E58; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital requirements (G32) | monetary policy actions (E52) |
| capital requirements (G32) | business cycle fluctuations (E32) |
| optimal monetary policy (E63) | procyclical effects of capital regulation (E44) |
| monetary policy (E52) | economic stabilization (E63) |
| central banks' interest rate adjustments (E52) | economic activity stabilization (E63) |
| bank capital state (G21) | monetary policy effectiveness (E52) |
| Germany and Japan's interest rate adjustments (E43) | economic activity stabilization (E63) |