A Theory of Macroprudential Policies in the Presence of Nominal Rigidities

Emmanuel Farhi, Iván Werning

NBER Working Paper No. 19313
Issued in August 2013
NBER Program(s):   EFG   ME

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.

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This paper was revised on June 10, 2015

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Document Object Identifier (DOI): 10.3386/w19313

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