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WP/09/257

Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy Papa N’Diaye

© 2009 International Monetary Fund

WP/09/257

IMF Working Paper Asia and Pacific Department Countercyclical Macro Prudential Policies in a Supporting Role to Monetary Policy Prepared by Papa N’Diaye Authorized for distribution by Nigel Chalk November 2009 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

This paper explores how prudential regulations can support monetary policy in reducing output fluctuations while maintaining financial stability. It uses a new framework that blends a standard model for monetary policy analysis with a contingent claims model of financial sector vulnerabilities. The results suggest that binding countercyclical prudential regulations can help reduce output fluctuations and lessen the risk of financial instability. More specifically, countercyclical rules such as countercyclical capital adequacy rules, can allow monetary authorities to achieve the same output and inflation objectives but with smaller adjustments in interest rates. The countercyclical rules can help stem swings in asset prices, lean against a financial accelerator process, and thereby help to lower risks of macroeconomic and financial instability. In economies with fixed exchange rates, where countercyclical monetary policy is not possible, prudential regulations can provide a useful mechanism for mitigating a run-up in asset prices and for promoting output stability. JEL Classification Numbers: E51, E58, E37, G13, G18. Keywords: Monetary policy, asset prices, macro prudentials, contingent claim analysis. Author’s E-Mail Address: pndiaye@imf.org

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Contents

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I. Introduction ............................................................................................................................3 II. Overview of the CCA............................................................................................................4 III. Model Overview ..................................................................................................................8 A. Aggregate Demand Equation ..................................................................................11 B. Inflation ...................................................................................................................11 C. Core Inflation—Phillips curve ................................................................................11 D. Okun’s Law Relationship........................................................................................12 E. Labor Income...........................................................................................................12 F. Exchange Rate .........................................................................................................12 G. Monetary Policy Rule .............................................................................................13 H. Yield Curve and Term Structure.............................................................................15 I. Spreads and Balance Sheets .....................................................................................15 J. Uncertainty ...............................................................................................................17 K. Debt Dynamics........................................................................................................17 L. Financial Regulations ..............................................................................................18 M. Equity...
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