NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Prudential Monetary Policy

Ricardo J. Caballero, Alp Simsek

NBER Working Paper No. 25977
Issued in June 2019
NBER Program(s):The Asset Pricing Program, The Corporate Finance Program, The Economic Fluctuations and Growth Program, The Monetary Economics Program

Should monetary policy have a prudential dimension? That is, should policymakers raise interest rates to rein in financial excesses during a boom? We theoretically investigate this issue 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, 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. An alternative intuition is that PMP raises the interest rate to create room for monetary policy to react to negative asset price shocks. The policy is most effective when there is extensive speculation and leverage limits are neither too tight nor too slack.

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Document Object Identifier (DOI): 10.3386/w25977

 
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