Expectations, Financial Markets and Monetary Policy

Monetary Policy and Macroprudential Regulations. We investigate the desirability of macroprudential regulations in a DSGE model with collateral and income borrowing constraints. We differentiate between credit demand and credit supply oriented macroprudential regulations by letting the macroprudential authority tighten, or relax, the financial constraints of borrowers and lenders separately. Additionally, we allow the central bank to use a Taylor rule augmented with credit growth targeting. Using a loss function in inflation and output for the central bank, we find that macroprudential regulations may help to decrease the volatility of inflation and output following a financial shock in the credit market. We analyse numerous policy configurations, and the loss function is minimized when the central bank aggressively responds to deviations of inflation and output, but not of credit growth, from their steady-state values and the macroprudential authority aggressively responds to deviations of credit growth and house price growth from their steady-state values. Given the monetary policy configuration that minimizes the loss function, credit demand macroprudential regulations appear to be more effective than their credit supply counterparts in minimizing the volatility of inflation and output.Should the Central Bank Target the Credit Spread? An Assessment Under Different Expectations Schemes. We investigate whether it is desirable to augment the standard Taylor rule with a response to developments in the credit market under different expectations schemes. We use a DSGE model with housing and credit markets, together with a banking sector, under both rational and extrapolative expectations. We develop a new approach to extrapolative expectations that ensures that both versions of the model have identical microfoundations. We consider an exogenous rise in risk appetite within the banking sector, and by using welfare analysis, we find that credit spread targeting leads to higher social welfare under both rational and extrapolative expectations. However, the optimal credit targeting coefficient in the Taylor rule depends on how the expectations are formed and is larger under extrapolative expectations. Our contribution illustrates the importance of the nature of expectations for the evaluation of alternative monetary policy rules.Macroeconomic Effects of Odyssean and Delphic Forward Guidance: an Analysis with Asset Prices and Boundedly Rational Agents. We use a New Keynesian model to investigate the effects of Odyssean and Delphic forward guidance on the dynamics of asset prices, inflation and output when the economy is at the Zero Lower Bound. In our model, agents are boundedly rational and form expectations using different forecasting rules. By using the Brock and Hommes (1997) switching mechanism, the agents tend to select the forecasting rule that performed relatively better in the recent past. Moreover, the central bank’s monetary policy credibility is endogenous and time-varying, as one of the forecasting rules is tied to the central bank’s ability to maneuver the economy towards the inflation and output targets. We find that Odyssean forward guidance, in the form of a commitment to keep the nominal interest rate lower for longer, has an expansionary effect on the economy and marginally decreases the volatility as measured by a loss function in inflation and output. Given the calibration of the parameter values in the model, the optimal horizon for Odyssean forward guidance is to commit to keeping the nominal interest rate at zero for three periods into the future. In contrast, the optimal Delphic forward guidance horizon is zero. This is because Delphic forward guidance prolongs deflation, increases the volatility of the economy and leads to lower output and lower growth of asset prices. Both Odyssean and Delphic forward guidance increase the central bank’s monetary policy credibility compared to the cases of no forward guidance in policymaking