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Macroprudential policy – closing the financial stability gap

Stephan Fahr (DG-Macroprudential Policy and Financial Stability, European Central Bank, Frankfurt am Main, Germany)
John Fell (DG-Macroprudential Policy and Financial Stability, European Central Bank, Frankfurt am Main, Germany)

Journal of Financial Regulation and Compliance

ISSN: 1358-1988

Article publication date: 13 November 2017

Abstract

Purpose

The global financial crisis demonstrated that monetary policy alone cannot ensure both price and financial stability. According to the Tinbergen (1952) rule, there was a gap in the policymakers’ toolkit for safeguarding financial stability, as the number of available policy instruments was insufficient relative to the number of policy objectives. That gap is now being closed through the creation of new macroprudential policy instruments. Both monetary policy and macroprudential policy have the capacity to influence both price and financial stability objectives. This paper develops a framework for determining how best to assign instruments to objectives.

Design/methodology/approach

Using a simplified New-Keynesian model, the authors examine two sets of policy trade-offs, the first concerning the relative effectiveness of monetary and macroprudential policy instruments in achieving price and financial stability objectives and the second concerning trade-offs between macroprudential policy instruments themselves.

Findings

This model shows that regardless of whether the objective is to enhance financial system resilience or to moderate the financial cycle, macroprudential policies are more effective than monetary policy. Likewise, monetary policy is more effective than macroprudential policy in achieving price stability. According to the Mundell (1962) principle of effective market classification, this implies that macroprudential policy instruments should be paired with financial stability objectives, and monetary policy instruments should be paired with the price stability objective. The authors also find a trade-off between the two sets of macroprudential policy instruments, which indicates that failure to moderate the financial cycle would require greater financial system resilience.

Originality/value

The main contribution of the paper is to establish – with the help of a model framework – the relative effectiveness of monetary and macroprudential policies in achieving price and financial stability objectives. By so doing, it provides a rationale for macroprudential policy and it shows how macroprudential policy can unburden monetary policy in leaning against the wind of financial imbalances.

Keywords

Acknowledgements

The views and opinions expressed in this article are those of the authors and do not necessarily reflect those of the European Central Bank or its Governing Council. The authors would like to thank Pablo Aguilar, Richard Barwell, Markus Behn, Frank Smets, Matija Lozej, Dirk Schoenmaker and Frank Smets for fruitful discussions and comments.

Citation

Fahr, S. and Fell, J. (2017), "Macroprudential policy – closing the financial stability gap", Journal of Financial Regulation and Compliance, Vol. 25 No. 4, pp. 334-359. https://doi.org/10.1108/JFRC-03-2017-0037

Publisher

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Emerald Publishing Limited

Copyright © 2017, Emerald Publishing Limited