Conventional, unconventional, and macro-prudential optimal policy.

As a consequence of the Great Recession (2007-09), the standard New Keynesian model for analyzing optimal policy has changed from assuming frictionless financial markets to including financial rigidities. These changes render the new framework suitable for analyzing the interaction between macroeconomic policy and financial events. In the present dissertation, I analyze optimal monetary, unconventional, and macro-prudential policy under commitment. I make use of a model with a banking sector that faces balance sheet constraints. In order to emphasize the role played by monetary policy in containing financial instability, in the first chapter the sole policy instrument is the nominal interest rate. Then, I allow the central bank to make use of additional policy instruments. In the second chapter, the central bank can undertake purchases of private securities. Finally, the third chapter considers the optimal mix between monetary and prudential policy. Chapter 1. In order to emphasize the role played by the monetary policy in containing financial instability, I assume that the sole policy instrument is the nominal interest rate. The main distortions in this economy are: the monopolistic competition, sticky prices, and the balance sheet constraint of banks. Sticky prices allow monetary policy to have real effects. This friction interacts with the financial distortions and create trade-offs for the central bank. If a financial shock hits, the gap between the actual and the efficient allocations widens. This fluctuation is costly and the central bank attempts to stabilize the financial market, but the cost is fluctuation in inflation. The main result of this chapter is that financial events matter. Stabilizing the financial sector is welfare improving, but with only one policy instrument the central bank cannot stabilize inflation and financial variables at the same time. A modified Taylor rule that consider a feedback parameter on the deviations of the cost of credit from its steady state level can implement the optimal policy. However, in this framework there are more objectives than policy instruments. In the next step, I allow the central bank to use asset purchases of private securities and I deal with the optimal mix of conventional and unconventional monetary policy. Chapter 2. In this chapter, I extend the model in chapter 1 in order to allow central bank to undertake direct lending to firms. Asset purchases is the unconventional policy instrument. In this framework, the central bank affect the price of credit (interest rate) and the provision of credit (lending in the private credit markets). The nominal interest rate influences the cost of credit. The credit intermediation by the central bank seeks to influence the availability of and the price of credit. Together, the conventional and unconventional policy can serve to stabilize inflation and the financial markets. The central bank can implement the optimal policy by means of two policy rules: the conventional Taylor rule which sets the nominal interest rate, and an asset purchases rule. Unconventional monetary policy can give a hand to conventional policy in order to stabilize inflation and financial activity. However, if the central bank cannot access to unconventional means to stabilize the economy, monetary policy would still need support from other branches of policy in order to achieve price and financial stability. Even if the economy can be stabilized with monetary policy alone, the question is can it be stabilized more effectively with macro-prudential policies working alongside monetary policy? The model in chapter three is designed to answer this question. Chapter 3. In this chapter, I consider the optimal policy mix between monetary and prudential policy. I make substantial modifications to the model used in chapters 1, and 2, in order to make it useful in assessing macro-prudential policies consistent with the evidence. In the model, the banks face balance sheet constraints. They lend to households and firms. Agent are heterogeneous: firstly, they are poor or rich; secondly, the groups differ by their degree of patience; thirdly, as in the empirical evidence, the poorest contribute more to aggregate consumption than to the aggregate disposable income, I capture this by allowing the poor-borrowers to possess external habits, while the rich-savers possess internal habits in consumption. The habits externality drives these agents to overconsume and to overborrow. Given that consumers with external habits overborrow from banks, there are motives to introducing reserve requirements as a prudential instrument. The reserve requirement acts to reduce the overconsumption. The increase in the reserve requirement makes the credit more expensive and the central bank can stabilize the economy when the shocks hit