Working Paper: NBER ID: w19313
Authors: Emmanuel Farhi; Iván Werning
Abstract: We propose a theory of monetary policy and macroprudential interventions in financial markets. We focus on economies with nominal rigidities in goods and labor markets and subject to constraints on monetary policy, such as the zero lower bound or fixed exchange rates. We identify an aggregate demand externality that can be corrected by macroprudential interventions in financial markets. Ex post, the distribution of wealth across agents affects aggregate demand and output. Ex ante, however, these effects are not internalized in private financial decisions. We provide a simple formula for the required financial interventions that depends on a small number of measurable sufficient statistics. We also characterize optimal monetary policy. We extend our framework to incorporate pecuniary externalities, providing a unified approach to both externalities. Finally, we provide a number of applications which illustrate the relevance of our theory.
Keywords: macroeconomic policy; macroprudential policies; nominal rigidities; aggregate demand externalities
JEL Codes: D5; D6; E3; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Macroprudential interventions (E44) | Aggregate demand externalities (E00) |
| Wealth distribution (D31) | Aggregate demand (E00) |
| Aggregate demand (E00) | Economic inefficiencies (D61) |
| Optimal monetary policy (E63) | Economic stability (E60) |
| Nominal rigidities (D59) | Necessity of macroprudential policies (E60) |