How can the coordination between monetary

and macroprudential policymakers affect

price and financial stability?
Sameer Somani

Candidate Number: XLNN9

ECON0042 – Independent Research Project

24/04/2023

Word Count: ----

Abstract
Since the Great Financial Crisis of 2008, macroprudential policies have become more prevalent in
ensuring financial stability, however, with significant spill-over effects between monetary policy and
financial stability, a degree of coordination between the two sets of policymakers may be required.
This paper analyses the potential benefits and costs of both a full-coordinated structure and a partially
coordinated structure where the monetary authority is given a dual mandate of price and financial
stability. It finds that the gains from coordination are significant and can be accessed through partial
coordination whilst also ensuring accountability.

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Introduction
Since the Great Financial Crisis of 2008, the usage of macroprudential policy tools worldwide has
risen significantly, more than doubling between 2008 and 2017 (Cerruti et al., 2017), as policymakers
around the world understood the importance of ensuring financial stability. Financial Stability is the
ability of the financial system to absorb shocks and the unravelling of financial imbalances (ECB,
2023) and incorporates the sector’s exposure to various kinds of risk including systemic risk, which
was a significant factor in the events of the 2008. Financial stability can be tackled through both
microprudential policy, which looks at ensuring the stability of banks individually, and
macroprudential policy, which seeks to address issues of systemic risk and the resilience of the
financial sector. Systemic risk refers to the potential of shocks within the financial sector to disrupt the
operation and supply of financial services and have negative effects on the real economy (FSB, 2009).

Prior to 2008, the financial sector had facilitated a drastic rise in household debt, primarily through
mortgage lending. Home equity-based borrowing in the US added $1.25 trillion to household debt
from 2002 to 2008 (Mian and Sufi, 2011), as banks and other mortgage lenders began issuing
increasingly leveraged and riskier mortgages to capitalize on the rapidly growing securitization
markets. Between 2005 and 2007, the average loan-to-value ratio of mortgages issued was roughly
95% (Geanakoplos, 2019), which leaves households at risk of defaulting on high mortgage payments
but also overstretched and likely to reduce consumption to make payments, which will have
significant consequences for the real economy. The additional home equity-based borrowing
accounted for 39% of defaults leading up to the collapse of the housing market (Mian and Sufi, 2011).
Furthermore, loopholes within US regulations had allowed some hedge funds and investment banks to
build up significant leverage ratios with the Lehman Brothers and Bear Stearns having ratios of 31:1
(SEC, 2007) and 35.6:1 (Fortune, 2007), which meant that a mere 3% fall in the firm’s asset value
would render them insolvent. The financial sector had not only exposed itself to significant default
risk but also ensured any shocks are amplified through the real economy.

Macroprudential policy tools, which seek to address issues of systemic risk, fall into 3 categories:
balance sheet restrictions, lending restrictions and policies that influence market structures (Bank of
England, 2011). Given the lack of cyclicality involved, I will not consider policy tools within the
latter category. Balance sheet restrictions include capital and liquidity requirements ensuring banks
have enough equity and liquid assets to cover any potential losses or debt. Balance sheet restrictions
can be used countercyclically to increase requirements in expansionary periods to absorb any potential
losses during busts. Typically, these are in the form of countercyclical capital buffers (CCyB) which
require banks to hold a given percentage of their risk-weighted assets, varied through the business
cycle, in Common Tier 1 Equity above the minimum capital requirements. Lastly, lending restrictions
are specifically designed to target the housing market and place limits on the amount that can be

2
borrowed against a property relative to its value (LTV limits) or relative to household income (DTI
limits). Loan-to-value and Debt-to-income limits typically are varied in response to financial stability
risks and hence have a cyclical nature.

Unfortunately, macroprudential policies and financial stability are not orthogonal to other policy tools
and objectives within the economy, especially monetary policy, and price stability objectives. First let
us consider the spill-over effects of monetary policy on financial stability objectives, where
accommodative monetary policies have adverse effects on financial stability through incentivizing
increased risk-taking behaviours by financial institutions. Rajan (2005) describes one channel through
which this occurs as the ‘search for yield’ where there exists inertia in targets for nominal returns after
interest rates fall which pushes banks and asset managers to higher yielding and riskier investments.
Following the Dot-com bubble burst in early 2000 and the events of 9/11, the Federal Reserve
lowered interest rates leading to a significant increase in risk-taking as credit spreads on high-yield
corporate bonds plummeted (BIS, 2004). This increased risk-taking can occur within commercial
banks and mortgage lenders also, as lenders seek to generate higher returns by lending to riskier
households or firms. Secondly, lower interest rates can impact perceptions of risk, given that lower
interest rates boost asset and collateral values (BIS, 2009). A firm with a higher stock price and hence
equity value relative to its corporate debt and liabilities will be perceived as less risky, leading to
capital flows from safer corporate debt to equities following a fall in interest rates. Overall, Malovana
and Frait (2016) verify this relationship by showing a negative relationship between monetary
tightening and the credit-to-GDP ratio, across the Czech Republic and select EMU countries from
2000 to 2015. Hence, with increased borrowing and bank risk, there exist significant negative effects
of looser monetary policy on financial stability.

On the contrary, macroprudential policies also have spill-over effects on price stability, through the
restrictions on credit supply driving up interest rates within the economy. Higher countercyclical
buffers reduce the supply of loanable funds available for credit providers to use, given that they are
required to keep additional reserves or equity capital. The fall in supply drives interest rates up which
affects price stability. With LTV limits being tightened, house prices as demand falls with higher
deposits required on mortgages (Richter et al., 2019). Falling house prices lead to a negative wealth
effect which lowers inflation. Richter et al. (2019) studies this effect across 56 advanced and emerging
economies and concluded that a 10% reduction in LTV limits is roughly equivalent to a 0.26%
increase in the policy rate. Hence, there also exists significant spill-over effects of macroprudential
policies on price stability.

The existence of these spill-over effects suggests that some degree of coordination is required between
monetary and macroprudential policymakers to avoid overshooting policy targets or policy tools
conflicting with each other. The importance of effective policymaking in ensuring price and financial

3
stability cannot be understated. The risks of financial instability are no better portrayed than in the
2008 Financial Crisis where the build-up of leverage within the economy meant that the collapse of
the housing bubble was amplified throughout the entire economy. During the crisis and the recession
that followed US unemployment doubled and GDP fell by 4.3% (US BLS, 2018). There was an 81%
increase in home foreclosures and a quarter of US households lost over 75% of their wealth as house
prices plummeted and savings were wiped out (Pfeffer et al., 2013). The risks of deflation from
pursuing financial stability through macroprudential tightening, are also well documented. Japan has
suffered from a prolonged period of low inflation since the 1990s, where the economy grew by 1.14%
annually between 1993 and 2003, far below the rate of other industrialized nations as debt burdens
grew and monetary policy entered a liquidity trap (ADB, 2015).

Despite these spill-over effects and the potential risks associated with them, macroprudential policy
committees within the US, UK and EMU have been separated from monetary policy counterparts. The
decision to separate the committees here can be attributed in part to the famous Tinbergen Separation
Principle. The Tinbergen Rule argued that to successfully target different objectives, at least different
policy instruments were required (1952), leading to the Separation Principle which applies the rule to
price and financial stability objectives. The coordination structure between policy committees within
the US, UK and EMU are roughly the same with each committee being assigned its own policy
objective with a shared secondary mandate of ensuring economic growth. Furthermore, although
separate, there exist significant links between monetary and macroprudential policy committees
within these currency areas, with overlapping membership and mandated information sharing.

Coordination between policymakers can occur through joint policy committees, where a single
committee is responsible for both price and financial stability objectives. Furthermore, partial
coordination also occurs with overlapping policy objectives where for example, a monetary policy
committee’s loss function places some weight on measures of financial stability. This paper seeks to
evaluate the benefits and costs of both full and partial coordination structures, in terms of promoting
price and financial stability goals, against a structure with two distinct policy committees, in hopes of
arriving at a set of policy recommendations for the maintaining or changing the status quo for the US,
UK and EMU.

The main conclusion of this paper suggests that there exist gains from coordinating monetary and
macroprudential policies resulting from monetary policy ‘leaning against the wind’, that could be
exploited through both a fully and partially coordinated structure. However, given the difficulties of
measuring financial stability and the resulting accountability issues that arise in a coordinated
structure, it is optimal to impose an additional financial stability mandate on the monetary authorities
of the US, UK and EMU to formalise a degree of coordination between the two policy committees,
whilst maintaining a separated structure.

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Methodology
This paper aims to amalgamate the various types of research that have addressed this question and
hence will be divided into four sections to explore each of the two main approaches individually, as
well as historical data and the closely related discussion of monetary policy ‘leaning against the wind,
(LAW). This paper begins by considering literature that employs a micro-founded dynamic stochastic
general equilibrium (DSGE) model approach to analyse the benefits of a fully coordinated structure,
which is typically an extension of Gertler and Karadi (2011). It then looks at various practical issues
of a single committee structure. Following on, it considers whether a separated structure with a dual
price and financial stability mandate for the monetary authority is optimal. Finally, it will then look at
historical data from China and a panel dataset to consider the performance of coordinated structures.

Given that this field of research is relatively new, only gaining importance post-2008, such a paper
which specifically considers the organisational structure of policymakers has yet to be created. Nier
and Kang (2016) is closely linked to this paper but focuses on the benefits of the spill-over effects
between monetary and macroprudential policy against a scenario where only one policy tool is used to
achieve both policy targets, as opposed to considering the organisational structure that optimises the
interactions.

There also exists research surrounding the benefits of coordinating macroprudential and monetary
policies across borders to internalise the cross-border spill-over effects that occur. However, this paper
reviews the interactions between the two sets of policymakers in a closed economy setting and hence
does not consider papers such as Kharroubi (2019) or Agenor (2021).

DSGE Models
The DSGE model proposed by Gertler and Karadi (2011) forms the basis of much of the research in
this field and allows us to explore an economy’s response path to various shocks, with a given
monetary policy response. De Paoli and Paustian (2017) build upon the DSGE model proposed by
Gertler and Karadi (2011) looking to include an endogenous macroprudential instrument. The model
includes households that supply capital to firms and labour to both firms and financial intermediaries,
as well as producers and retailers. Bankers (who themselves are part of households) are incentivized
to lend to producers at a rate above the borrowing rate, as they receive the spread of the loan and
deposit rates as return. However, they are also able to divert a fraction of deposits away from lending
as their return. The issue arises because of the potential for depositors to force the bank into
bankruptcy in which case the depositors are unable to recover the bonus paid to the household hence
creating an agency problem and the necessity for macroprudential policies. Macroprudential policy is

5
modelled as a cyclical tax or subsidy on bank deposits, which affects the spread of the loan and
deposit rates, varying the incentives for keeping reserves and lending.

The model studies how different coordination structures minimise welfare losses following an
exogenous cost-push shock, relative to the optimal unconstrained coordinated case. Welfare losses are
modelled as a function of inflation and price deviations as well as the effective interest rate, where
higher interest rates generated by fluctuations in the credit spread generate credit constraints and
hence inefficiencies. When considering the case with separate policy committees or the Nash
Equilibria case, the welfare function is split with the monetary authority’s loss function being
dependent on inflation and output and the macroprudential policy dependent on output and effective
interest rates. The results are significantly in favour of coordination between policymakers where the
welfare loss of the Nash equilibrium case relative to the coordinated case is equivalent to 0.3% of
steady state consumption discounted to before the shock. To put this in perspective, this is roughly
equivalent to a present value of $400 of additional consumption for every US household following a
shock at current consumption levels (FRED, 2023), hence the potential gains from coordination are
meaningful. Note also that the Nash Equilibria case is similar in many regards to the framework
implemented within the UK, with both policy committees understanding each other’s loss function
and with overlapping secondary objectives of the MPC and FPC to promote employment and growth.

Van der Ghote (2021) seeks to develop the model proposed above by including business cycle
fluctuations. This allows the paper to analyse how policies have an impact on the frequency and
magnitude of the economic cycle, even if policy interventions only occur during a small period during
the cycle. The results show only a modest improvement in social welfare of 0.13% over non-
coordinated policy interventions, with monetary policy sharing the burden of financial stability at the
expense of the increased price and employment volatility. The paper also sheds light on the
determinants of the size of welfare gains from policy coordination. The gains from coordination
increase with the size and value of the financial system intuitively, which is modelled by the
efficiency wedge for lending between households and financial intermediaries. Also, coordination
becomes more effective with increased nominal price rigidities modelled by the average frequency of
price changes. These could be significant with the rise of peer-to-peer (P2P) lending systems which
could diminish this efficiency wedge over the decade where the global P2P lending market is expected
to grow by a factor of ten from its 2021 size of $82.3 billion (Acumen Research, 2021).

In the aftermath of the crisis, house prices in New Zealand grew by an annual rate of 10% during Q1
in 2016, the second highest rate globally at the time. House prices grew by 30% relative to income
between 2010 and 2016, forcing the Reserve Bank of New Zealand to tighten LTV limits significantly
between 2013 and 2016. However, Funke et al. (2018) observed negligible spill-over effects between
LTV requirements and consumer prices, by formulating a DSGE model to mirror the housing boom.

6
LTV limits were found to be effective with the model suggesting a 1% tightening of LTV limits
leading to a fall in house prices by 1.9%. Monetary policy, although a factor in fuelling the housing
boom in 2016, has historically not been the main driver in housing bubbles which are typically
attributed to sector-specific supply shocks. Hence, with few spill-over effects between the policies, the
gains from coordinated policies are minimal when considering the housing boom in New Zealand in
2016. However, the lack of welfare gains from coordination in this example arises from the negligible
spill-over effects between policies, which is contested by empirical evidence discussed earlier, and not
by inherent issues with a coordinated structure.

Agenor and Jackson (2022) add another element to their model considering the effects of biased
policymaker preferences on the benefits of fully coordinated policies. Biased preferences refer to the
degree of importance individual policymakers place upon their mandate (i.e. price stability and
growth for monetary authorities or financial stability for macroprudential policy) relative to also
considering household welfare. Under biased preferences, policymakers are less sensitive to the spill-
over effects of their policy tools, and hence the paper finds that coordination gains increase under
biased preferences. Furthermore, under coordination optimal policy weights should be determined by
the magnitude of spill-over effects between the policy tools, such that if monetary policy has a
significantly larger spill-over effect on financial stability compared to macroprudential policy on price
stability then to maximise social welfare a higher weight should be placed on financial stability within
the joint mandate as to limit monetary policies excessive spill-over effects. Overall, given most
policymakers are mandated to be biased to some degree, the paper is clearly in support of joint policy
committees for monetary and macroprudential policy to maximise welfare.

Overall, the literature supports the existence of welfare gains from full coordination but is unclear as
to the magnitude of these gains. The extensive empirical literature confirming the presence of spill-
over effects opposes the claim made by Funke et al. (2018) and hence allows for the possibility of
coordination gains. De Paoli and Paustian (2017) and Van der Ghote (2021) reinforce the existence of
welfare gains and lastly, Agenor and Jackson (2022) show that welfare gains from coordination are
increasing with biased policy mandates, which are currently implemented in the UK, EMU and the
US.

Practical Considerations
Financial stability is inherently difficult to measure throughout most of the economic cycle.
Policymakers can seek to increase financial stability through macroprudential tools but verifying
whether policies have allowed for a sufficient level of stability is difficult without a measure like CPI
inflation for price stability. This gives rise to accountability issues with a joint policy committee,
where policymakers could succumb to ‘target culture’ and prioritise the more prominent target of

7
price stability, whilst neglecting financial stability (Broadbent, 2018). That is not to exclude the
possibility of any potential coordination but to suggest that if the performance of the joint committee
is measured on ensuring price and financial stability, it is natural for policymakers to lean towards
fulfilling the observable target of price stability more, as if to ‘play to the test’.

With distinct policy committees, this is less of an issue with each committee being more focused on
its own goal, as per its mandate, ensuring that both objectives are being considered equally. It is
intuitive to argue that two committees biased towards their objectives, will correct much of the spill-
over effects from the other policy tool. However, a single biased committee has no opposing
policymaker to correct its bias, which is significantly more dangerous (Broadbent, 2018). This view
directly opposes that of Agenor and Jackson (2022), which suggests that coordination under bias
would internalise spill-over effects instead of leaving them unchecked.

Leaning Against the Wind

‘Leaning against the wind’ (LAW) monetary policy is a strategy that entails setting monetary policy
tools at tighter levels than what is required to ensure price stability for promoting increased financial
stability. It involves giving the monetary authority a dual mandate of price and financial stability to
incentivize monetary authorities to dampen excessive lending and risk-taking by banks, given the
significant spill-over effects between loose monetary policy and financial stability. Although the gains
from a coordinated structure arise from LAW, with a fully coordinated committee internalising the
spill-over effects from monetary tools, this section will explore literature considering LAW with
separated policy committees by giving monetary authorities a dual mandate.

When considering monetary policy in the absence of macroprudential policy tools, the costs of LAW
are clear. Svensson (2017) showed that not only does LAW have costs for the economy in terms of
lower target inflation and higher unemployment through normal times but also deepens any eventual
recession. Although LAW dampens excessive lending, the weaker economy going into a crisis would
mean that the shock is amplified with households less well off before the crisis and hence unable to
absorb the shock themselves.

However, with the introduction of macroprudential policy tools much of the burden for financial
stability has been alleviated. Unfortunately, the existence of coordination gains suggests that
macroprudential policies are unable to maintain stability alongside optimal monetary policy. Agur and
Demertzis (2019) verify this showing that the costs of fully correcting the spill-over effects of
monetary policy on financial stability are too high and hence an optimal macroprudential policymaker
will allow interest rate changes to pass through to increased bank risk-taking. However, could it be
optimal for monetary policy to still engage in LAW alongside macroprudential tools?

8
Krug (2018) supports this suggestion that monetary policy should still engage in LAW as a last resort
with active macroprudential policymakers ensuring financial stability. Angelini et al. (2014) state that
regardless of coordination, using both monetary and macroprudential tools is optimal for restoring
equilibrium. The paper concludes that in non-crisis times, macroprudential tools can improve the
credit-to-GDP ratio and hence improve financial stability but the spill-over effects onto monetary
policy objectives suggest the need for coordination in normal times. However, the gains from a price
and financial stability mandate for the monetary authority in crisis times are independent of full
coordination between policymakers hence supporting LAW monetary policy with separated
committees.

However, the weight of the financial stability objective within the monetary authority’s loss function
is also critical. Agur (2019) suggests that introducing only a small degree of LAW has a negative
welfare effect as financial stability conditions dominate between the two policy committees hence
moving the economy to an equilibrium with a higher output gap. However, since the monetary policy
authority only places a small weight on financial stability, the new equilibrium entails a higher loss
compared to the equilibrium without LAW. Hence, for increased LAW to reduce losses, the weight on
financial stability must be large enough to make the two policy committees’ preferences similar.
Although we are considering losses for only the monetary policy authority, if preferences for LAW are
set according to social preferences this may entail sub-optimal policies since the macroprudential
authority is still focused on only improving financial stability. The paper concludes by stating that
although an ‘open mandate’ of pursuing social welfare cannot be given to both committees, the
weights on each objective must be carefully calibrated across the committees to mirror social
preferences.

Figure 1 - Agur (2019)

Historical Evidence

9
When considering the effectiveness of coordination, the People’s Bank of China provides a perfect
example with policies jointly set since the introduction of dynamic provisioning tools in 2011. Jiang et
al. (2019) seek to analyse the impact of coordination on financial stability and sustainability on both a
micro-level, by considering the risky asset ratio, and on a macro-level by considering house prices and
stock price bubbles. Sustainability is defined as providing the conditions for long-term financial
development to ensure the financial system continues to allocate resources efficiently to support the
real economy. In short, stock price bubbles measured by the average price-to-earnings ratios of the
Shanghai Composite Index are a result of financial unsustainability. The paper finds that for
controlling bank risk-taking both policies should be implemented in a coordinated and countercyclical
manner supporting the arguments of De Paoli and Paustian (2017) and Van der Ghote (2021).
Furthermore, for housing bubbles, the policies should initially be implemented in opposing directions
to avoid a short-run rise in house prices due to further expected rises in borrowing costs. Lastly, for
regulating stock market bubbles’ macroprudential policy should respond first with monetary policy
LAW if needed. The variations in requirements across different shocks suggest that increased
coordination may be beneficial to respond correctly to different types of shocks.

However, Jiang et al. (2019) focus on the impact of the coordination of policies on financial stability
within a single economy only, and hence I considered the relative performance of countries with fully
coordinated and separated structures. I employed a panel data set from 2000 to 2020 covering the 10
most active countries in terms of macroprudential policy usage (Appendix 1) which includes the
average of bank z-scores and the squared deviations of CPI inflation (from a 2% target) as the
outcome variable 𝑌𝑖𝑡 . To account for the single or separate policy committees, I generated binary
variables that describe the year in which macroprudential policies were implemented. 𝑋𝑖𝑡 describes
the introduction of macroprudential policies in a coordinated framework and similarly 𝑍𝑖𝑡 denotes the
introduction of a separate macroprudential policy committee.

𝑌𝑖𝑡 = 𝛼 + 𝛽1 𝑋𝑖𝑡 + 𝛽2 𝑍𝑖𝑡 + 𝛽3 𝑡 + 𝑢𝑖 + 𝑒𝑖𝑡

The results (Appendix 2) suggest that coordinated policy committees achieve financial stability than a
separated structure, with the introduction of macroprudential policy tools having a significant positive
effect on financial stability albeit higher with a fully coordinated structure. This is against the
concerns raised by Broadbent (2018) which suggested that joint policy committees are likely to place
a higher weight on the more observable objective of price stability and supports the theory that
coordination entails monetary policy engages in LAW to some degree. Furthermore, the effect of
macroprudential tools on inflation seems to be negligible, however, this may be a result of the limited
number of countries considered.

Conclusion

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Understanding the interactions between monetary and macroprudential policymakers and how to
leverage these to ensure optimal policymaking is crucial in modern society, especially given the
highly interconnected global financial. Throughout this paper, there is significant literature in support
of coordination gains, whether that be through fully coordinated structures as shown by De Paoli and
Paustian (2017) and Van der Ghote (2021) or the historical performance of macroprudential tools in
coordinated structures. These coordination gains also exist in ‘partially coordinated’ structures where
the monetary authority is given a second mandate of financial stability as shown by Angelini et al.
(2014) and Krug (2018).

However, although not supported by the panel dataset, the practical issues stemming from the
difficulty in measuring financial stability cannot be ignored. Accountability is crucial in ensuring
optimal policymaking, and the costs of neglecting financial stability, such as in the Great Financial
Crisis of 2008, are significant. Hence, to leverage the coordination gains whilst also ensuring
accountability, it seems optimal to impose a secondary mandate of financial stability on the monetary
authorities of the US, UK and EMU to incentivize some degree of LAW, despite the costs involved for
price stability. The weight of financial stability within the monetary authority’s loss function is critical
and must be considered in conjunction with the loss function of the macroprudential authority.

Currently, within the US, EMU and the US there exists significant links between the two policy
committees with overlapping policy committee members and the requirement for each policy
authority to consider its spill-over effects on each other. However, although these considerations may
limit excessively loose monetary policy in expansionary periods, there is a requirement for financial
stability to be included with the mandate of the monetary authority to realize the gains from
coordinating policies. It must be said though that there exists little research surrounding the effect of
monetary policy ‘leaning against the wind’ alongside an active macroprudential authority, and hence
the recommendation is made with significant caution.

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Appendix
Appendix 1 – Top 10 Most Active Countries in Macroprudential Policy Usage

Country Policy Committee Structure

Hong Kong Joint
Singapore Joint
Korea Separated
Canada Separated
Israel Joint
Norway Joint
Netherlands Separated
New Zealand Separated
Slovak Republic Separated
United Kingdom Separated

Source: IMF iMaaP Database and Correa et al. (2017)

Appendix 2 – Panel Data Regression on Yearly Average Commercial Bank Z-

Scores and Inflation Deviations

(1) (2)
VARIABLES inflation zscore

singlecom 3.515 5.409**

(3.074) (2.607)
sepcom 2.927 3.156*
(2.180) (1.689)
date -0.00144 -0.000556
(0.00106) (0.000444)
Constant 27.77 25.73***
(19.36) (7.920)

Observations 210 199

Number of country1 10 10
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

Source: FRED (2023), IMF iMaaP Database and Correa et al. (2017)

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