Household debt,macroprudential rules,and monetary policy

Today's Canadian economy features a historic high of household debt and persistently low growth rate. The average debt-to-GDP ratio has reached the level experienced in the U.S. just prior to the recent financial crisis. In this paper, we ask whether monetary policy should lean against the household indebtedness or macroprudential policies are better suited for the task. To provide a quantitative answer, we develop a small open economy dynamic stochastic general equilibrium model featuring a micro-founded banking sector. We estimate the model using Canadian data and conduct policy experiments. Our findings favor macroprudential approach to reining in indebtedness: using monetary policy that reacts to household debt increases inflation volatility and lowers borrowers' welfare, while using macroprudential policies such as lowering the loan-to-value ratio limit increases borrowers' welfare.     

Housing market dynamics and macroprudential policies

In this paper, we analyze the implications of macroprudential and monetary policies for credit cycles, housing market stability and spillovers to consumption. We consider a countercyclical loan‐to‐value (LTV) policy that responds to a credit‐to‐income ratio, and we compare its effectiveness with a permanent tightening of the LTV ratio and a monetary policy rule that responds to credit. To this end, we construct a dynamic stochastic general equilibrium model with housing market, household debt and collateral constraints, and we estimate it with Canadian data using Bayesian methods. Our study suggests that a countercyclical LTV ratio is a useful policy to reduce spillovers from the housing market into consumption and to lean against housing market boom–bust cycles. It performs better than the permanent tightening of the LTV ratio—a policy that has been used in a number of countries—and the monetary policy rule, both in terms of the stabilization of household indebtedness and spillovers into consumption. Monetary policy that leans against the wind is the least desirable due to its large adverse consequences on the real economy.     

Monetary and macroprudential policy with foreign currency loans

In a number of countries a substantial proportion of mortgage loans is denominated in foreign currency. In this paper we demonstrate how their presence affects economic policy and agents’ welfare. To this end we construct a small open economy model with financial frictions, where housing loans can be denominated in domestic or foreign currency. The model is calibrated for Poland - a typical small open economy with a large share of foreign currency loans (FCL). We show that the presence of FCLs negatively affects the transmission of monetary policy and deteriorates the output-inflation volatility trade-off it faces. The trade-off can be improved with macroprudential policy but the outcomes are still worse than under this same policy mix applied to an economy with domestic currency debt. We also demonstrate that a high share of FCLs is harmful for social welfare, even if financial stability considerations are not taken into account. Finally, we show that regulatory policies that discriminate against FCLs may have a negative impact on economic activity and discuss the redistributive consequences of forced currency conversion of household debt.     

Optimal monetary and macroprudential policies: Gains and pitfalls in a model of financial intermediation

We estimate a quantitative general equilibrium model with nominal rigidities and financial intermediation to examine the interaction of monetary and macroprudential stabilization policies. The estimation procedure uses credit spreads to help identify the role of financial shocks amenable to stabilization via monetary or macroprudential instruments. The estimated model implies that monetary policy should not respond strongly to the credit cycle and can only partially insulate the economy from the distortionary effects of financial frictions/shocks. A counter-cyclical macroprudential instrument can enhance welfare, but faces important implementation challenges. In particular, a Ramsey planner who adjusts a leverage tax in an optimal way can largely insulate the economy from shocks to intermediation, but a simple-rule approach must be cautious not to limit credit expansions associated with efficient investment opportunities. These results demonstrate the importance of considering both optimal Ramsey policies and simpler, but more practical, approaches in an empirically grounded model.     

Impact of US monetary policy rate shock and other external shocks on the Hong Kong economy: A factor‐augmented vector autoregression approach

This paper uses the factor‐augmented vector autoregression framework to study the impact on the Hong Kong economy of the diverging monetary policies by the Fed, the European Central Bank (ECB) and the Bank of Japan as well as the slowdown of the Mainland economy. The empirical results show that shocks in US monetary policy rate mainly affect interest rate‐sensitive sectors in Hong Kong and that monetary easing from the European Central Bank and the Bank of Japan somewhat offsets the impact of tightening of the Fed. The transmission of external shocks is through trade and capital markets. Real variables such as real GDP growth and the unemployment rate are more sensitive to the economic slowdown in Mainland China. It is estimated that the combined effect of the four external shocks will on average lower Hong Kong's quarterly GDP growth by 0.6 percentage points and quarterly inflation by 0.2 percentage points in the first four quarters. However, Hong Kong's financial stability, particularly with regard to loan quality, banks’ capital and liquidity, is well maintained by macroprudential policies, suggesting that Hong Kong's financial system is resilient to external shocks.     

Macroprudential policy and the inward transmission of monetary policy: The case of Chile,Mexico, and Russia

This paper studies whether domestic macroprudential policy may attenuate the inward transmission of monetary policy shocks from the United States to domestic bank lending growth in three emerging market economies—Chile, Mexico, and Russia. Identification relies on banks’ heterogeneous exposure to prudential policies and the fact that foreign monetary policy shocks are exogenous from the perspective of these economies. After analyzing the effects of the aggregate domestic prudential policy stance, we focus on specific prudential policies targeting mortgage and consumer loans, as well as foreign‐currency deposits. Although our overall results are mixed, we find evidence that the strength of international monetary policy spillovers varies depending on the stance of domestic macroprudential policy. In particular, a tighter reserve requirement stance over foreign‐currency deposits in Chile dampens the effect of an international monetary policy shock on domestic local‐currency lending, but reinforces that on foreign‐currency lending, whereas in Russia, it dampens the effect on both local‐currency and foreign‐currency lending, although to different degrees. Prudential policies targeting the asset side of banks’ balance sheets, such as mortgage loans or consumer credit, are found to amplify international monetary policy spillovers in some cases and attenuate it in others, depending on the country context.     

The effects of economic policy uncertainty on China’s economy: evidence from time-varying parameter FAVAR

ABSTRACT

This article explores the effects of China’s economic policy uncertainty (EPU) on its fiscal policy, monetary policy and a wide range of macro-economic variables using a time-varying parameter FAVAR model. Based on monthly data from 07/2003 to 08/2017, the time-varying structure of the model allows us to capture the time-varying characteristics of the macro-economic variables and which channel is relevant. Empirical results reveal that the reaction of monetary and fiscal policies to EPU is highly asymmetric across macro-economic circumstances. Loose monetary and fiscal policies are adopted in response to EPU shocks during the financial crisis, while policies are moderately tightened after the crisis. The China Interbank Offered Rate (Chibor) responds more sensitively and severely than M2 to EPU shocks. Additionally, EPU shocks have a significant and negative impact on economic growth, consumption, exchange rates, bonds and the stock market, but showing a positive impact on credit, real estate and fixed asset investment (which might be due to China’s special economic market environment and the high investment return). The results indicate that EPU shocks significantly affect macroeconomic fundamentals through precautionary savings and financial market channels but lose their effectiveness through a ‘real options’ effect.     

Countercyclical capital rules for small open economies

The growing literature on macroprudential regulation focuses on how a combination of monetary and macroprudential policies can boost macroeconomic and financial stability. We contribute to this literature by developing a DSGE model that assesses the effectiveness of countercyclical capital regulation in small open economies, in monetary unions or with exchange rate pegs, where policymakers do not have full control over traditional stabilisation instruments such as nominal interest and exchange rates. In such economies, macroprudential policy could potentially play an even more relevant role in mitigating the adverse effects of macro-financial feedback loops. To validate the model’s ability to replicate the stylised facts of financial crises, we calibrate using data for the Irish economy, the scene of a recent housing crash. Our results demonstrate that the pro-active use of countercyclical capital regulation – in the form of Basel III-type rules – can help attenuate boom-bust cycles driven by over-optimistic expectations. We also find that more aggressive action by regulators during the release phase can bolster the economy’s ability to absorb a negative shock.     

Unconventional monetary policy in the Euro Area: Shadow rate and light effets

We assess transmission mechanisms and the macroeconomic impact of unconventional monetary policy (UMP) in the Euro Area. We estimate a FAVAR model and use a shadow rate to measure the stance of the monetary policy. The ECB's UMP measures adopted at the zero lower bound (ZLB) have sustained the real economy. For instance, in 2016, without UMP, investment would have been lower by 9%, consumption lower by 2% and the unemployment rate higher by 0.9%. However, the impact of unconventional monetary shocks is weaker and less persistent than those emanating from conventional monetary policy. Furthermore, the difference in the transmission of monetary policies between countries of the Euro Area was more pronounced during the period 2009-2016. This suggests that the ZLB has decreased the efficiency of monetary policy and accentuated the heterogeneity of the Euro Area.     

Mortgage lending,monetary policy,and prudential measures in small euro‐area economies: Evidence from Ireland and the Netherlands

This paper examines whether the increased use of macroprudential policies since the global financial crisis has affected the impact of (euro‐area and foreign) monetary policy on mortgage lending in Ireland and the Netherlands, which are both small open economies in the euro area. Using quarterly bank‐level data on domestic lending in both countries for 2003–2018, we find that restrictive euro‐area monetary policy shocks reduce the growth of mortgage lending. We find evidence that stricter domestic prudential regulation mitigates this effect in Ireland, but not so in the Netherlands. There is some weak evidence for an international bank lending channel that can be mitigated by stricter lender‐based domestic prudential regulation.     

Fiscal expansion, monetary policy, interest rate risk premia, and wage reactions

We examine the macroeconomic implications of fiscal policy in a small open economy, with emphasis on the interactions between fiscal, monetary and labour market policies. The paper uses the NBNZ-DEMONZ macroeconometric model. Novel features of the model are that it includes an endogenous interest rate risk premium (IRRP), and forward-looking monetary and fiscal policy reaction functions which capture the essence of New Zealand's Reserve Bank and Fiscal Responsibility Acts. The most important empirical result is that the postulated IRRP, proxying financial market mechanisms, can contribute at least as much as the monetary policy reaction function to maintaining price stability. Also of significance are that an income tax cuts package shows more damped real GDP and underlying inflation paths than does an expenditure increases equivalent; and that the inflationary and real sector impacts of a personal income tax cut package depend heavily on how the cut is `shared' between firms and workers. The nature and interdependence of monetary and fiscal policies and labour market conditions are therefore crucial to the macroeconomic outcomes.     

Dynamic Stochastic General EQUILIBRIUM ‐ BASED Assessment of Nonlinear Macroprudential Policies: Evidence from Hong Kong

In the wake of the 2008–2009 global financial crisis, the macroeconomic discussion has returned to the topic of proactive macroprudential policies. The use of loan‐to‐value (LTV) policies to curb booming property markets has long been used by Hong Kong's monetary authorities to actively manage the potential fallout from housing price bubbles. In 2013 the Hong Kong authorities supplemented the LTV policies with property transfer taxes. Here, we also analyse the merits of these tax‐based macroprudential policies in the dynamic stochastic general equilibrium framework. Furthermore, we calibrate the impact of both countercyclical macroprudential policies employed in conjunction with forward guidance. We conclude that both policy approaches can limit the pace of housing price increases. As regards the comparison of LTV and tax‐based measures, it turns out that property acquisition taxes are more effective.     

A comparison of optimal policy rules prior to and during inflation targeting: empirical evidence from Bank of Canada

We examine policy rules that are consistent with inflation targeting (IT) framework in a small macroeconomic model of the Canadian economy. We set up an optimal linear regulator problem and derive policy rules to compare the dynamics of pre-IT and IT eras. We find that while the optimal monetary policy rule in the pre-IT period is best described with a loss function that attaches equal weight to price stability, financial stability and output stability; the IT era is dominated by the price stability objective followed by the financial stability and output stability, consecutively. Moreover, we do not find an explicit role for exchange rate stability in the objective function of the Bank of Canada for both monetary policy eras. We, then, compare the properties of the derived optimal rules with those of an ad hoc Taylor rule for the IT period. In response to inflationary shocks, Taylor rule brings down inflation rates more quickly compared to the derived policy rules, but at the cost of a higher sacrifice ratio and more volatile interest rates.     

Asymmetric effects of monetary policy shocks on economic performance: empirical evidence from Turkey

This study investigates the asymmetric effects of monetary policy shocks on the macroeconomic variables of exchange rate, output and inflation for an emerging economy ? Turkey ? by using monthly data between 1990 and 2014. We employ the innovative nonlinear vector autoregressive model of Kilian and Vigfusson (2011), which allows us to observe the effect of different stances (tight or loose) and different sizes (small or large) of monetary policy actions. Our empirical evidence reveals that tight monetary policy, which, in this case, is captured with a positive shock to interest rate, decreases exchange rate, output and prices, as economic theory suggests. Loose monetary policy, which is captured with a negative shock to interest rate, has the opposite effect on these variables. However, the effects of loose monetary policy are weaker than the effects of tight monetary policy because loose monetary policy shocks are less effective than tight monetary policy shocks. Moreover, as the magnitude of a shock increases, the difference between the effects of tight and loose monetary policy policies also increases.     

Monetary and fiscal policy interactions in a post Keynesian open-economy model

Using a post Keynesian model, this study aims to analyze the stabilizing role of fiscal and monetary policies in an open economy with a managed exchange rate regime. The real exchange rate is modeled as an endogenous variable and inflation explained using the conflicting claims approach. The dynamic properties of macroeconomic equilibrium are evaluated in different regimes of fiscal and monetary policies. The main result of this study suggests that the preferred policy regime is the one in which economic authorities are complementary and fiscal policy plays an explicitly active role. In this regime, the fiscal policy must commit to the target for the rate of capacity utilization and the monetary authority must commit to the inflation target.     

Evaluating monetary policy with financial stability objective: rules vs. discretion

This article explores whether adding the goal of financial stability to the more traditional goals of output and price stability could improve optimality of monetary policy. A Dynamic Stochastic General Equilibrium model that endogenously incorporates financial frictions is used to derive optimality conditions across rule-based and discretionary monetary policy environments. The results indicate that it is optimal for the Central Bank to keep output below the potential level in the short term so as to dampen the inflationary effects arising from supply and financial shocks. When the economy is exposed to a financial shock, both leverage and credit spread rise significantly, thereby tipping the economy into a financial crisis and raising the probability of macroeconomic risk.     

Macroeconomic Effects of Asset‐Price Shocks in a Globalized Financial Market

In this paper, I study a model in which shocks to asset prices affect the real sector of the economy through a credit channel. As financial markets become internationally integrated, the economy becomes less vulnerable to domestic asset‐price shocks, but more vulnerable to foreign asset‐price shocks. To the extent that monetary policy stabilization is feasible and desirable, the globalization of financial markets shifts the focus of monetary policy from domestic asset prices to worldwide asset prices.     

Transmission of monetary policy in times of high household debt

This paper explores whether the degree of household indebtedness can affect the effectiveness of monetary policy. We take an interacted panel VAR approach, using a panel of 23 countries, thereby obtaining several interesting findings, such as the responses of consumption and investment to monetary shocks are stronger in high levels of household debt. Furthermore, such responses become larger in a contractionary monetary policy stance rather than in an expansionary one, which suggests that monetary policy shocks have asymmetric effects. We have also found that monetary policy has a relatively larger impact in countries with higher share of adjustable-rate loans. Finally, we have found that when a country is in a high-debt state and in a contractionary policy stance, monetary policy is more powerful in countries with a higher share of adjustable-rate loans. We conjecture that these findings support the presence of a cash-flow channel with respect to the transmission of monetary policy in a high household debt state.     

How does capital regulation react to monetary policy? New evidence on the risk-taking channel

Before the subprime crisis, financial stability was a microprudential issue addressed by capital regulation and unrelated to monetary policy. The financial crisis put this paradigm to the test and turned the spotlight on the relationship between financial stability and monetary policy. Hence, the following question arises: how does capital regulation react to monetary policy? This article seeks to answer this question. We analyze the link involving monetary policy and capital regulation through the risk-taking channel in Brazil. The findings suggest that banks react to monetary policy by changing the amount of loan provisions as well as the capital adequacy ratio (CAR). An important novelty of the study is the evidence that there is no trade-off between provisions and CAR, which are important tools used by banking supervisors. The key result of the article is that banks react to the macroeconomic environment differently from what is expected by banking supervision, i.e., there exists a paradox between the microprudential view and the macroprudential view. Thus, in terms of practical implication, a banking supervision strategy for financial stability must take into account the effects of monetary policy.     

Oil shocks and monetary policy rules in emerging economies

We examine the effects of shocks in the oil market on key macroeconomic variables in small open economies using a dynamic stochastic general equilibrium model with sticky prices and imperfect competition under different monetary policy rules. The numerical solutions show that the types of exchange rate regimes and monetary policies could partly explain the trends in macroeconomic volatilities considering negative shocks to oil supply (Hamilton, 1983) and positive shocks to oil demand (Kilian, 2009). These findings are confirmed in vector autoregressive responses for Chile and Israel with inflation targeting under flexible exchange regimes and Hong Kong with fixed regime.