Modelling Alternative Macroprudential Policies with Financial Frictions

Abstract

This paper studies the effectiveness of macroprudential policy in a New Keynesian DSGE model with financial frictions. The financial sector is modelled vis-à-vis Gertler and Karadi (2011) with endogenous bank leverage ratio. Macroprudential policies operate independently of standard monetary policy targeting price stability, and the simulation results show that they can mitigate shocks and stabilise credit. First, a countercyclical feedback rule to regulate the loan-to-value (LTV) ratio of the borrowing household is imposed. On the other hand, a proportional tax policy is implemented to restrict the leverage ratio of financial intermediaries during economic booms. The LTV ratio regulation significantly dampens economic fluctuations but shifts credit towards the business sector. Comparatively, the tax policy stabilises the aggregate credit market more effectively by directly controlling the balance sheet of financial intermediaries. Nonetheless, policymakers may face high administering and monitoring costs when implementing the tax policy, as well as a notable trade-off between economic growth and financial stability. The qualitative results remain robust when a "leaning-against-the-wind" monetary policy is introduced. The paper concludes with an extended discussion on the potential trade-off between the pursuit of price and finance stability.