Working Paper: NBER ID: w25977
Authors: Ricardo J. Caballero; Alp Simsek
Abstract: Should monetary policymakers raise interest rates during a boom to rein in financial excesses? We theoretically investigate this question using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, there are conditions under which small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors’ balance sheets. The policy is most effective when the recession is more likely and leverage limits are neither too tight nor too slack. With shadow banks, whether PMP “gets in all the cracks” or not depends on the constraints faced by shadow banks.
Keywords: prudential monetary policy; asset prices; financial stability; economic downturns
JEL Codes: E00; E12; E21; E22; E30; E40; G00; G01; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prudential monetary policy (PMP) (E60) | asset prices (G19) |
| asset prices (G19) | asset price crash (G01) |
| prudential monetary policy (PMP) (E60) | aggregate demand (E00) |
| optimists' wealth share (F62) | economic stability (E63) |
| prudential monetary policy (PMP) (E60) | asset price crash (G01) |