IMF endorses macroprudential (again)


The IMF has produced new economic modelling endorsing the use of macroprudential policy to dampen credit cycles in currency constrained EU countries. The study undertook modelling for two Eurozone countries, and was aimed to examining whether maroprudential policy was an appropriate way to govern credit when neither interest rates nor the currency are not being set according to local economic conditions.

Obviously Australia would not “normally” be in such a quandary.  But it is now with interest rates low enough to risk asset bubbles, yet under pressure to go lower still because the currency is refusing to correct as it should. Analogous to the European countries used in the IMF modelling.

The paper itself is a wellspring of econometric gobbledygook but the findings are straight forward, macroprudential works.

Our paper contributes to this debate by studying the optimal policy mix needed within a currency union, where country- and sector-specific boom and bust cycles cannot be directly addressed with monetary policy. Specifically, we focus on the case of the EMU, where the European Central Bank (ECB) has the mandate of price stability at the union-wide level. Before the crisis, the GIIPS countries were not able to use monetary policy to cool down their economies and financial systems, address asset and house price bubbles or abnormal credit growth. Therefore, the use of other policy instruments in a currency union can potentially help in stabilizing the business and financial cycle. We provide a quantitative study on how monetary and macroprudential measures could interact in the euro area. We pay special attention to coordination issues between the ECB, who will have additional macro-prudential

and supervision powers in the newly created banking union, and national supervision authorities. Early contributions to the debate on the role of macroprudential policies include several quantitative studies conducted by the Bank for International Settlements (BIS) on the costs and benefits of adopting the new regulatory standards of Basel III (see Angelini et al., 2011a; and MAG, 2010a,b), and in other policy institutions (see Bean et al., 2010; and Roger and Vlcek, 2011). Other authors have also suggested that the use of macroprudential tools could improve welfare by providing instruments that target large fluctuations in credit markets. In an international real business cycle model with financial frictions, Gruss and Sgherri (2009) study the role of loan-to-value (LTV) limits in reducing credit cycle volatility in a small open economy, while Lambertini, Mendicino and Punzi (2011) look at the e§ect of LTV ratios on welfare in a model with housing and risky mortgages. Bianchi and Mendoza (2011) analyze the effectiveness of macroprudential taxes to avoid the externalities associated with ‘overborrowing’. Borio and Shim (2008) point out the prerequisite of a sound financial system for an effective monetary policy and, thus, the need to strengthen the interaction of prudential and monetary policy. IMF (2009) suggests that macroeconomic volatility can be reduced if monetary policy does not only react to signs of an overheating financial sector but if it is also combined with macroprudential tools reacting to these developments.5 Angelini et al. (2011b) focus on the interaction between optimal monetary and macroprudential 4The European Systemic Risk Board (ESRB) remains as the main macroprudential oversight body for the European Union, but its role is limited to issuing non-binding warnings. For details, see Goyal et al. (2013). 5Bank of England (2009) lists several reasons, why the short-term interest rate may be ill-suited and should be supported by other measures to combat financial imbalances.6 policies in a set-up where the central bank determines the nominal interest rate and the supervisory authority can choose countercyclical capital requirements and LTV ratios. Unsal (2011) studies the role of macroprudential policy when a small open economy receives large capital inflows.

We quantify the role of monetary and macroprudential policies in stabilizing the business cycle in the euro area using an estimated Dynamic Stochastic General Equilibrium (DSGE) model. The model includes: (i) two countries (a core and a periphery) which share the same currency and monetary policy; (ii) two sectors (non-durables and durables, which can be thought of as housing); and (iii) two types of agents (savers and borrowers) such that there is a credit market in each country and across countries in the monetary union. The model also includes a financial accelerator mechanism on the household side, such that changes in the balance sheet of borrowers due to house price fluctuations affect the spread between lending and deposit rates. In addition, risk shocks in the housing sector affect conditions in the credit markets and in the broader macroeconomy. The model is estimated using Bayesian methods and includes several nominal and real rigidities to Öt the data, as in Smets and Wouters (2003) and Iacoviello and Neri (2010). Basel III calls for regulators to step in when there is excessive credit growth in the economy. We want to study the pros and cons of reacting to credit indicators, either by using monetary or macroprudential policies. Having obtained estimates for the parameters of the model and for the exogenous shock processes, we proceed to study different policy regimes. In all cases, we assume that the optimal policy aims at maximizing the welfare of all households in the EMU by maximizing their utility function taking into account the population weights of each type of household in each country. First, we derive the optimal monetary policy when the ECB optimizes over the coeficients of the Taylor rule that reacts to EMU-wide consumer price index (CPI) inflation and real output growth. We find that the optimal Taylor rule strongly reacts to deviations of CPI inflation and output growth from their steady state values, as is typical in the literature. Afterwards, we extend the monetary policy rule to react to credit aggregates. We find that the extended Taylor rule improves welfare with respect to the original one, with borrowers being worse off under some conditions. Next, we introduce a macroprudential instrument that ináuences credit market conditions by affecting the fraction of liabilities (deposits and loans) that banks can 6Some recent papers have also studied the role of macroprudential regulation in the euro area: Beau, Clerc and Mojon (2012) analyze macroprudential policies in an estimated DSGE model of the euro area but do not distinguish between di§erent countries. Brzoza-Brzezina, Kolasa and Makarski (2013) distinguish between a core and a periphery in a model with optimal monetary and

macroprudential policies in the euro area, but do not estimate the model. In both cases, the credit friction consists in a borrowing constraint ‡ la Iacoviello (2005).7 lend. This instrument can be thought of as additional capital requirements, liquidity ratios, reserve requirements or loan-loss provisions that reduce the amount of loanable funds by financial intermediaries and increase credit spreads. We find that by introducing macroprudential policies welfare further increases, but that there are also winners and losers of including these measures. As we discuss in Section 4, optimal monetary and macroprudential policies are welfare improving under housing demand or risk shocks: these measures reduce the volatility of real variables by offsetting accelerator e§ects triggered by these shocks. However, when technology shocks hit the economy, macroprudential policies have the opposite effect and magnify the countercyclical behavior of the lending-deposit spread. This imposes larger fluctuations of consumption, housing investment and hours worked for borrowers and, thus, reduces their welfare. Therefore, identifying the source of the credit and house price boom is crucial for the success of policy measures that react to financial variables. Finally, we find that when macroprudential policies are left to national regulators instead of being conducted at the EMU-level, the optimal response of the macroprudential instrument is very similar.

In this paper, we have studied the optimal mix of monetary and macroprudential policies in an estimated DSGE model of the euro area. We have found that in a variety of scenarios and calibrations, the introduction of a macroprudential rule would help in reducing macroeconomic volatility and hence in improving EMU-wide welfare. At the same time, we have observed that macroprudential policies ìlend a handîto monetary policy by reducing accelerator effects and thus, requiring smaller responses of the nominal interest. We have also shown that the effects of macroprudential regulations can affect savers and borrowers differently. The policy that improves welfare in the EMU the most – which would be to have macroprudential policies respond to the credit-to-GDP ratio – reduces the welfare of borrowers by inducing a too countercyclical response of the lending-deposit spread. Improving welfare for all citizens in the EMU will only be achieved, if macroprudential policies respond to nominal credit growth. Finally, we have also found that there are no negative spillover effects of regulation from one member state to another. Having macroprudential policies set at the national or EMU wide levels will therefore not change the outcome.

In our post-GFC world ,this is inevitable. Get on with it, RBA.

David Llewellyn-Smith
Latest posts by David Llewellyn-Smith (see all)


  1. migtronixMEMBER

    “Therefore, identifying the source of the credit and house price boom is crucial for the success of policy measures that react to financial variables”

    Oh geez how do ever identify the source of credit and house price boom? It can’t be the open derivatives books out there misdirecting investment and forcing ever more leverage to clear what’s already been bet against can it?
    No no must be borrower greed, lets make it harder for them.

  2. But clearly this advice does not apply to Australia because Australia is different.

    In Australia real estate prices only ever go up. And up. And up.

    A 40% reduction in price is just not possible, like that which happened after the GFC in Ireland, in the US, in Spain …

    • My properties in Perth dropped in value by about 30% post GFC
      They have now recovered. Developers are providing smaller 2 and 1 bed units that sell in the sweet spot range of $550k to $700k in my area. Australia is a very desirable country to live in. Assuming the banksters will at some late stage defend the Australian economy and lower the currency to an economically effective level, all will be well.

      • “Assuming the banksters will at some late stage defend the Australian economy and lower the currency to an economically effective level, all will be well.

        Big assumption. If the Banksters did care about the American people why would they care about the Australian people.

        I don’t buy it. When Australia’s turn come we will just have to accept it. Those that have prepared by creating financial buffers will in general do better than those that haven’t prepared.

  3. HnH,

    My position on macroprudential is that since the housing market is a pseudo market (i.e., no shorting mechanisms to counter the margin lending), macroprudential will be essential to bring the pseudo market closer to symmetry.

    The question is; by how much?

    From the symmetry argument alone, zero shorting must equal zero leverage. But this is not practically feasible since very few have enough cash to buy a house outright. Historically, a max cap of 30-40% LVR may be good. Is there any rational behind this number? Or is it just an art?

  4. Which one would you rather have in charge?

    “housing prices in German cities have been rising so strongly since 2010 that a possible overvaluation cannot be ruled out.” – German Central Bank, October 2013

    “I think there are a lot of people, the minute housing prices start to pick up they say, ‘Oh my goodness, we’ll all be rooned.’ The minute housing prices start to pick up they imagine it’s a bubble.” – Australian Central Bank, October 2013

    • …and to give the above statements some more context

      German Houses : 15% underpriced against rent
      18% underpriced against income

      Australian Houses : 46% overpriced against rent
      24% overpriced against income