## _012913 - EXECUTIVE SUMMARY

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### Overview
- The recent crisis showed that price stability does not guarantee macroeconomic stability. Dangerous financial imbalances developed under low inflation and small output gaps.
- To ensure macroeconomic stability, policy has to include financial stability as an additional objective, requiring macroprudential tools that can target specific sources of financial imbalances.
- Experience and knowledge on the effectiveness, calibrations, and interactions of macroprudential policies with each other and with monetary policy remain limited.
- *January 29, 2013*

### Key findings
- Ideally, with macroprudential policies perfectly targeting the sources of threats to financial stability, monetary policy should remain primarily focused on price and output stability.
- Even in the ideal benchmark, the conduct of both policies will need to take into account the effects they have on each other’s main objectives.
- Practical constraints:
  - Macroprudential policies cannot be targeted perfectly and do not fully offset financial shocks or distortions.
  - Institutions are imperfect; time inconsistency and political economy constraints can arise.
  - If these weaknesses are important, monetary policy may have to take a greater role in preserving financial stability and accept the associated trade-off.
  - Where monetary policy is constrained (for example, within currency unions and in many small open economies), there will be greater demands on macroprudential policies.
- Using macroprudential policies to offset shortcomings in weakly conducted monetary policy is rarely optimal.
- Institutional implications:
  - Policy coordination can improve outcomes, making it advantageous to assign both policies to the central bank.
  - Concentrating multiple objectives in one institution can muddy its mandate, complicate accountability, and reduce credibility.
  - Safeguards (separate decision-making, accountability, and communication structures) are needed to distinguish between the two policy functions.

### Conceptual framework and operational conclusions
- When price rigidities are the only distortion, stabilizing inflation is generally equivalent to maximizing welfare; monetary policy should aim at stabilizing inflation.
- When financial distortions are present, price stability is not sufficient and financial stability becomes an additional intermediate policy goal.
- Operationalizing financial stability is difficult because of the large range of financial distortions and their changes over time; it is not yet possible to operationalize financial stability to the same degree as price stability.
- The task of preserving financial stability is to mitigate financial distortions and the risks associated with them, with intermediate targets linked to aggregate implications (for example, leverage in the banking or household sectors, capital and liquidity positions of financial intermediaries, foreign exchange composition of assets and liabilities).
- Limitations of monetary policy for financial stability:
  - Causes of financial instability are not always related to system liquidity.
  - Pricking an asset price bubble or mitigating financial distortions can require large changes in the policy rate.
  - Monetary policy is a blunt tool when distortions are sector-specific.
  - Overreliance on monetary policy for financial stability can create public confusion about central bank objectives.

### Policy tools and examples
- Macroprudential tools span a variety: procyclical capital adequacy requirements, loan-to-value caps (LTV’s), taxes/levies, and constraints on the composition of assets and liabilities of financial institutions.
- Examples from practice:
  - Banking-sector tools:
    - countercyclical capital buffers (as used in Bulgaria and proposed internationally);
    - dynamic provisioning (as used in Spain and several countries in Latin America);
    - reserve requirements (as used in Brazil, Peru, and Turkey);
    - levies on short-term borrowing (recently introduced in Korea).
  - Household-sector tools:
    - loan-to-value (LTV) caps for mortgage loans;
    - debt-to-income (DTI) limits (used in Hong Kong SAR, Korea, and Poland).
  - Other tools:
    - liquidity requirements and net open position limits to address maturity mismatches or foreign exchange exposures;
    - capital flow management measures—including residency based measures—when borrowing is external in certain circumstances.
- Emerging market economies have been pioneers in refocusing instruments on macroprudential uses.

### Macroprudential policies: scope, manifestations, and trade-offs (Section 14)
- Primary role:
  - Best targeted at financial stability and relatively less well suited to managing aggregate demand.
  - Foremost role is to constrain (ex ante) incentives for excessive risk-taking and force financial market participants to internalize contributions to systemic risk.
- Manifestations of systemic risk:
  - excessive leverage;
  - weak lending standards and liquidity positions;
  - balance sheet mismatches of financial institutions and borrowers.
- Multiple tools are required and typically need adjustment as macro-financial conditions and systemic risk evolve.
- Reactive (ex-post) interventions (bailouts) trade off targeted intervention against inefficiency, fiscal burden, taxpayer costs, and moral hazard.
- Interactions with monetary policy:
  - Monetary policy rates affect leverage and asset/liability composition by altering borrowing costs, domestic asset prices, and exchange rates.
  - Well-targeted macroprudential policies can contain undesirable effects of monetary policy and create “room for maneuver” for monetary policy.
  - Examples cited:
    - Conservative DTI limits can contain defaults from monetary tightening (Igan and Kang, 2011).
    - Limits on LTV ratios can reduce vulnerabilities when accommodative monetary policy drives up asset prices.
    - Higher capital requirements or tighter leverage or liquidity ratios can contain increases in bank risks in response to expected lax monetary policy (Farhi and Tirole, 2012).
- Macroprudential tools as buffers and relaxation in stress:
  - Capital buffers can complement monetary policy in times of stress and smooth monetary policy across the cycle.
  - Dynamic provisions in Spain provide some relief in downturns (Jimenez and others, 2012).
  - Tight LTV ratios can help contain fallout from property busts and keep monetary transmission open.
  - Relaxation of macroprudential tools in stress can be appropriate but must ensure resilience to future shocks; evidence on effectiveness of relaxation is mixed and markets have tended to view reductions adversely.
- Effects on output and prices:
  - Macroprudential policies constrain borrowing and thus can affect overall output and prices; quantitative effects are not well understood due to limited data.
  - If policies operate perfectly, monetary policy can offset macroprudential effects on output if monetary policy is effective.
  - Complications arise when macroprudential tightening occurs in stress while monetary policy is at its lower bound.
- Theoretical literature:
  - Monetary and macroprudential policies are generally complements, not substitutes, though results vary by shock type.
  - For financial shocks, macroprudential policy is often optimal because it is more targeted.
  - For productivity shocks, conclusions depend on the nature of financial distortions.
  - For aggregate demand shocks, monetary policy alone is optimal if it stabilizes both inflation and output; otherwise there is scope for using macroprudential policy alongside monetary policy.
  - Existing analytical methods suggest the optimal calibration of monetary policy reactions to output and inflation does not change markedly when macroprudential policy is also used.

### Imperfect macroprudential policies and implications (Section III & A)
- Identification and measurement challenges:
  - Distinguishing efficient market responses from inefficient ones caused by market failures or externalities is difficult.
  - Balancing Type I and Type II errors is a core difficulty.
- Calibration limits:
  - Determining buffer size in booms and timing/scale of release during stress is unresolved.
  - Some macroprudential tools have never been tried in practice.
  - Interactions among different distortions and tools are not well understood.
- Model limitations:
  - Models often lack rich descriptions of crisis causes and non-linearities and assume tools work perfectly.
- Institutional constraints on deployment:
  - Legal/institutional limits on tool access or cooperation with microprudential agencies.
  - Accounting issues (dynamic provisioning vs. international financial reporting standards).
  - Need for fiscal authority participation for time-varying levies or tax treatment; legal changes may be required.
  - Macroprudential authorities may lack expertise or information to identify and calibrate risks.
- Costs of imperfect application:
  - Imperfect targeting or excessive tightness can worsen distortions or drive vulnerabilities outside the regulatory perimeter.
- Consequence for monetary policy:
  - Weak macroprudential application makes it more likely monetary policy must respond to financial conditions (e.g., by “leaning” against the credit cycle).
  - Monetary authorities should monitor broader financial indicators: buoyant credit growth, increasing leverage, and other financial indicators, and adapt policy horizons.

### Monetary policy constraints and small open economies (Section B & Box 4)
- When monetary policy is constrained (currency pegs, currency unions, limited autonomy), demands on macroprudential policy increase.
- Macroprudential policy should not be overburdened; it needs strong fiscal and structural policy complements.
- Coordination across countries in a currency union is desirable (coordinated, not necessarily harmonized).
- Small open economy examples and lessons:
  - Capital flows influenced by domestic/global policy rate differentials can fuel credit growth, leverage, and maturity/currency mismatches.
  - Targeted macroprudential measures can change flow composition and reduce systemic risk (examples: levy on non-core FX liabilities in Korea; higher risk weights, tighter LTV ratios, limits on FX lending in some CESEE countries).
  - A combination of capital and reserve requirement increases can control credit surges associated with capital flows, complementing policy-rate changes and enhancing policy autonomy (example: Brazil).
  - Use of targeted macroprudential measures aligns with the IMF’s institutional view on managing capital flows.

### Institutional and political economy considerations (Sections C & 43)
- Institutional constraints and coordination frictions:
  - Different institutions can hold fundamentally different views of the economy and financial system, reducing effective coordination.
  - A microprudential regulator in charge of macroprudential policies may tighten regulation in a recession.
  - Political economy: regulators without political independence may be reluctant to constrain credit because of short-run unpopularity and revenue effects.
  - Frequency of macroprudential policy use can be limited when broad approval is required or instruments have strong distributional implications.
- Legal mandate, accountability, and communication:
  - Required elements include a strong legal mandate and appropriate powers, dedicated decision-making structures, accountability, and communication tools.
  - Communications policy provides clarity on objectives and actions.
- Role of the central bank and safeguards:
  - Advantages of a leading central bank role: expertise, data sharing, analysis of side effects, potential shielding from political influence.
  - Risks of assigning dual objectives to the central bank: temptation to use inflation to repair private balance sheets, time-consistency conflicts, lower credibility, reputational risks, and communication challenges.
  - Recommended safeguards when both functions are housed in the central bank:
    - Separate decision-making structures (e.g., separate policy committees).
    - Separate accountability and communications structures (e.g., separate reports to the legislature).
    - Legislative clarification of governance and primary objectives.
- Macroprudential function outside the central bank:
  - Central bank can still play a leading role (e.g., chairing the committee) though constitutional constraints may limit participation or formal powers.
  - When the central bank conducts microprudential supervision, an external macroprudential body may lack authority to recommend supervisory tool use.

### Evidence, channels, and empirical magnitudes (Annex and Box summaries)
- Aggregate consequences of financial market imperfections:
  - Asymmetric information, limited liability, and limits on enforcement lead to financial distortions (moral hazard, collateral constraints, excessive risk-taking).
  - Distortions create externalities: agents do not internalize systemic risk, leading to excessive leverage, liquidity risk, exposure to risky assets, or exchange-rate risk.
  - Strategic complementarities and expectations of bailouts can exacerbate correlated risk-taking.
  - Regulatory/tax regimes (differential tax treatment of equity and debt, tax deductibility of mortgage interest, non-recourse mortgages) can encourage excessive risk-taking.
  - At the aggregate level, these imperfections imply amplification and persistence: shocks generate larger and longer-lasting responses in aggregate variables than in their absence.
- Channels through which monetary policy can affect financial stability (Box 2 and Annex Table 1):
  - Balance sheet (default) channel: monetary easing relaxes collateral constraints, lowering external financing costs and easing credit; tightening can increase defaults. Empirical evidence: Sengupta (2010); Jiménez and others (2009); Gertler and Gilchrist (1994); Asea and Blomberg (1998).
  - Risk-taking channel: low policy rates can encourage banks to over-leverage or reduce screening; evidence: Jiménez and others (2009); Ioannidou and others (2009); Merrouche and Nier (2010).
  - Risk-shifting channel: higher rates can induce risk-shifting; evidence: Gan (2004); Landier and others (2011).
  - Asset-price channel: monetary policy affects asset prices with mixed empirical findings; evidence includes Altunbas and others (2012); Del Negro and Otrok (2007); IMF (2009).
  - Exchange-rate channel: policy-rate differentials influence capital flows and carry trades; evidence: Hahm and others (2012); Merrouche and Nier (2010); Jonsson (2009).
- Quantitative illustration cited:
  - At a five-year horizon a 100 basis point hike in the policy rate would reduce annual house price appreciation by only 1 percentage point, compared to a historical average annual increase of 5 percent, but would reduce GDP growth by 0.3 percentage points.

### Policy implications and recommendations (synthesized)
- Keep macroprudential policies primarily focused on financial stability rather than macroeconomic stabilization where other tools (monetary, fiscal) are available and effective.
- Use multiple, well-targeted macroprudential instruments calibrated to the specific sources of systemic risk and adjusted as conditions evolve.
- Employ macroprudential policies ex ante to constrain risk-taking and reduce the need for costly ex-post interventions.
- Coordinate macroprudential and monetary policy, recognizing complementarities: macroprudential tools can attenuate side effects of monetary policy and provide buffers that support monetary transmission.
- Ensure any relaxation of macroprudential measures in stress is consistent with resilience to future shocks and mindful of market perceptions.
- Strengthen quantitative analysis and country-specific work to better calibrate macroprudential tools and understand their interactions.
- Ensure macroprudential authorities have access to a broad set of tools, adequate legal/institutional frameworks, data, and expertise; involve fiscal authorities where necessary.
- Avoid overburdening macroprudential policy where monetary policy constraints exist; complement with fiscal and structural policies.
- Prioritize strengthening monetary policy frameworks and credibility rather than substituting them with macroprudential measures when monetary effectiveness is weak.
- Implement institutional safeguards when assigning dual objectives to a single agency: separate decision-making, accountability, and communication structures.

*Source: _012913 — EXECUTIVE SUMMARY and excerpts from “THE INTERACTION OF MONETARY AND MACROPRUDENTIAL POLICIES” (International Monetary Fund).*

### EXECUTIVE SUMMARY

### _012913 - EXECUTIVE SUMMARY

### Overview
- The recent crisis showed that price stability does not guarantee macroeconomic stability. Dangerous financial imbalances developed under low inflation and small output gaps.
- To ensure macroeconomic stability, policy has to include financial stability as an additional objective, requiring macroprudential tools that can target specific sources of financial imbalances.
- Experience and knowledge on the effectiveness, calibrations, and interactions of macroprudential policies with each other and with monetary policy remain limited.

### Key findings
- Ideally, with macroprudential policies perfectly targeting the sources of threats to financial stability, monetary policy should remain primarily focused on price and output stability.
- Even in the ideal benchmark, the conduct of both policies will need to take into account the effects they have on each other’s main objectives.
- In practice, constraints exist:
  - Macroprudential policies cannot be targeted perfectly and do not fully offset financial shocks or distortions.
  - Institutions are imperfect; time inconsistency and political economy constraints can arise.
  - If these weaknesses are important, monetary policy may have to take a greater role in preserving financial stability and accept the associated trade-off.
  - Where monetary policy is constrained (for example, within currency unions and in many small open economies), there will be greater demands on macroprudential policies.
- Using macroprudential policies to offset shortcomings in weakly conducted monetary policy is rarely optimal.
- The interaction between monetary and macroprudential policies has implications for institutional design:
  - Policy coordination can improve outcomes, making it advantageous to assign both policies to the central bank.
  - Concentrating multiple objectives in one institution can muddy its mandate, complicate accountability, and reduce credibility.
  - Safeguards (separate decision-making, accountability, and communication structures) are needed to distinguish between the two policy functions.

### Conceptual framework and operational conclusions
- When price rigidities are the only distortion, stabilizing inflation is generally equivalent to maximizing welfare; monetary policy should aim at stabilizing inflation.
- When financial distortions are present, price stability is not sufficient and financial stability becomes an additional intermediate policy goal.
- Operationalizing financial stability is difficult because of the large range of financial distortions and their changes over time; it is not yet possible to operationalize financial stability to the same degree as price stability.
- The task of preserving financial stability is to mitigate financial distortions and the risks associated with them, with intermediate targets linked to aggregate implications (for example, leverage in the banking or household sectors, capital and liquidity positions of financial intermediaries, foreign exchange composition of assets and liabilities).
- Monetary policy is not best suited to maintaining financial stability because:
  - Causes of financial instability are not always related to system liquidity.
  - Mitigating effects of financial distortions or pricking an asset price bubble can require large changes in the policy rate.
  - Monetary policy is a blunt tool when distortions are sector-specific.
  - Overreliance on monetary policy for financial stability can create public confusion about central bank objectives.

### Policy tools and examples
- Macroprudential tools span a variety: procyclical capital adequacy requirements, loan-to-value caps (LTV’s), taxes/levies, and constraints on the composition of assets and liabilities of financial institutions.
- Several of these tools have a long history, often used for microprudential or monetary objectives; emerging market economies have been pioneers in refocusing instruments on macroprudential uses.

### Institutional and research context
- The paper builds on prior IMF work: IMF 2011a, Lim and others (2011), Nier and others (2011), and complements country case studies and an accompanying background paper.
- It is part of a larger effort including forthcoming staff papers on unconventional monetary policy, the costs of macroprudential policies, and the relationship between macro- and microprudential policies, and contributes to the Fund’s work on financial stability in line with the 2011 Triennial Surveillance Review and the 2012 Financial Surveillance Strategy.
- The paper focuses on interactions between monetary and macroprudential policies and does not attempt comprehensive coverage of all macroprudential policy aspects; broader institutional questions are left for future work by MCM and LEG.

### Boxed analytical insight (Aggregate consequences of financial market imperfections)
- Asymmetric information, limited liability, and limits on enforcement lead to financial distortions (moral hazard, collateral constraints, excessive risk-taking).
- These distortions create externalities: agents do not internalize systemic risk, leading to excessive leverage, liquidity risk, exposure to risky assets, or exchange-rate risk.
- Strategic complementarities and expectations of bailouts can exacerbate correlated risk-taking.
- Existing regulatory and tax regimes (differential tax treatment of equity and debt, tax deductibility of mortgage interest, non-recourse mortgage loans) can encourage excessive risk-taking.
- At the aggregate level, these imperfections imply amplification and persistence: shocks generate larger and longer-lasting responses in aggregate variables than in their absence.

*January 29, 2013*

### 14.      Macroprudential policies should focus on financial stability and are relatively less well

### 14.      Macroprudential policies should focus on financial stability and are relatively less well suited to managing aggregate demand

### Scope and primary role
- Macroprudential policies are best targeted at financial stability and are relatively less well suited to managing aggregate demand; using them for aggregate demand management can create additional distortions by constraining behavior beyond the origins of financial distortions.
- When effective countercyclical monetary and fiscal tools are available, it is desirable to keep macroprudential policies focused on financial stability to avoid overburdening them and the risk that policymakers overestimate their achievable outcomes.
- The foremost role of macroprudential policies is to constrain (ex ante) incentives for excessive risk-taking and force financial market participants to internalize their contributions to systemic risk, reducing this risk mainly over the cycle but also across institutions.

### Manifestations of systemic risk and need for multiple tools
- Systemic risk can manifest as:
  - excessive leverage;
  - weak lending standards and liquidity positions;
  - balance sheet mismatches of financial institutions and borrowers.
- Because of this variety, multiple macroprudential tools are required and typically need adjustment as macro-financial conditions and systemic risk evolve.
- Many macroprudential instruments are microprudential in nature but are being repurposed with financial stability objectives in mind.

### Range of macroprudential tools (examples from the text)
- Banking-sector tools:
  - countercyclical capital buffers (as used in Bulgaria and proposed internationally);
  - dynamic provisioning (as used in Spain and several countries in Latin America);
  - reserve requirements (as used in Brazil, Peru, and Turkey);
  - levies on short-term borrowing (recently introduced in Korea).
- Household-sector tools:
  - loan-to-value (LTV) caps for mortgage loans;
  - debt-to-income (DTI) limits (used in Hong Kong SAR, Korea, and Poland).
- Other tools:
  - liquidity requirements and net open position limits to address maturity mismatches or foreign exchange exposures;
  - capital flow management measures—including residency based measures—when borrowing is external in certain circumstances.

### Trade-offs of reactive vs. ex-ante approaches
- Preserving financial stability through reactive (ex-post) policies such as bailouts:
  - allows targeted intervention but can be inefficient, overburden fiscally weak sovereigns, impose costs on taxpayers, and be poorly targeted;
  - creates incentives for risk-taking because private agents may expect ex-post interventions even if policymakers rule them out.
- Even if some ex-post interventions are used, macroprudential policies are needed to mitigate their costs by reducing incentives for risk-taking created by expected bailouts and decreasing the intensity of required ex-post interventions.

### Interactions with monetary policy
- Policy interactions require consideration of side effects each tool has on the other's targets; distortions typically respond to economic conditions and policy.
- Monetary policy rates affect leverage and asset/liability composition by altering borrowing costs, domestic asset prices, and exchange rates, operating through channels that:
  - shape ex-ante risk-taking incentives via leverage, short-term borrowing, or foreign-currency borrowing;
  - affect ex-post tightness of borrowing constraints and possibly exacerbate asset-price and exchange-rate externalities and leverage cycles.
- Macroprudential policies well-targeted at sources of distortions can contain undesirable effects of monetary policy, reduce policy dilemmas, and create “room for maneuver” for monetary policy.
  - Examples from the text:
    - conservative DTI limits can contain defaults from monetary tightening (Igan and Kang, 2011);
    - limits on LTV ratios can reduce vulnerabilities when accommodative monetary policy drives up asset prices;
    - higher capital requirements or tighter leverage or liquidity ratios can contain increases in bank risks in response to expected lax monetary policy (Farhi and Tirole, 2012).

### Channels through which monetary policy can affect financial stability (Box 2 — summary)
- Low monetary policy rates can:
  - create incentives for banks to over-leverage or reduce screening efforts due to asymmetric information;
  - lead other agents to seek more risk for higher returns;
  - be worse if accommodative policy is prolonged.
- Monetary easing relaxes collateral constraints as asset prices rise and net worth increases, lowering external financing costs and easing credit; tightening can increase defaults.
- Monetary policy affects asset-price and exchange-rate externalities via collateral valuation and capital flows, potentially triggering leverage cycles and foreign-currency borrowing issues.
- The strength of these channels varies with the cycle stage, financial structure, and capital account openness; structural changes (e.g., securitization) and openness modify transmission.

### Macroprudential tools as buffers and their relaxation in stress
- Macroprudential tools can provide buffers against unexpected shocks, lessening the risk of monetary policy hitting the lower bound and supporting monetary transmission:
  - capital buffers can complement monetary policy in times of stress and smooth monetary policy across the cycle;
  - dynamic provisions in Spain provide some relief in downturns (Jimenez and others, 2012);
  - tight LTV ratios can help contain fallout from property busts and keep monetary transmission open.
- Relaxation of macroprudential tools in times of financial stress can be appropriate in principle, but must ensure resilience to future shocks; evidence on effectiveness of relaxation is mixed and markets have tended to view reductions in prudential ratios during downturns adversely.

### Effects on output and prices, and policy coordination
- Macroprudential policies constrain borrowing and thus can affect overall output and prices; effects may differ by tool and stage of the cycle, but quantitative effects are not well understood due to limited data.
- If policies operate perfectly, the presence of side effects alone does not majorly change conduct: monetary policy can offset macroprudential effects on output if monetary policy is effective.
- Complications can arise when macroprudential tightening occurs in stress while monetary policy is at its lower bound.
- Theoretical literature (Box 3) generally finds monetary and macroprudential policies are complements, not substitutes, though results vary by shock type:
  - In response to financial shocks, it is often optimal to use macroprudential policy primarily because it is more targeted.
  - Following productivity shocks, conclusions depend on the nature of financial distortions; sometimes monetary policy alone is optimal, other times macroprudential tightening is warranted.
  - For aggregate demand shocks, monetary policy alone is optimal if it stabilizes both inflation and output; if stabilizing inflation costs output and lending imposes systemic risk externalities, there is scope for using macroprudential policy alongside monetary policy.
- Existing analytical methods suggest the optimal calibration of monetary policy reactions to output and inflation does not change markedly when macroprudential policy is also used.

### Policy implications and recommendations (synthesized from the text)
- Keep macroprudential policies primarily focused on financial stability rather than macroeconomic stabilization where other tools (monetary, fiscal) are available and effective.
- Use multiple, well-targeted macroprudential instruments calibrated to the specific sources of systemic risk and adjusted as conditions evolve.
- Employ macroprudential policies ex ante to constrain risk-taking and reduce the need for costly ex-post interventions.
- Coordinate macroprudential and monetary policy, recognizing complementarities: macroprudential tools can attenuate side effects of monetary policy and provide buffers that support monetary transmission.
- Ensure any relaxation of macroprudential measures in stress is consistent with resilience to future shocks and mindful of market perceptions.

*Source: _012913 - 14.      Macroprudential policies should focus on financial stability and are relatively less well suited to managing aggregate demand*

### 28.      The precise interaction between monetary and macroprudential policy will depend on

### 28.      The precise interaction between monetary and macroprudential policy will depend on

### III. EXPERIENCES AND LIMITATIONS — Overview
- The interaction between monetary and macroprudential policies is country-specific and can reduce trade-offs and increase room for maneuver for monetary policy when macroprudential policies contain asset-price, credit, or exchange-rate related risks.
- Model-based conclusions rely on strong simplifications: macroprudential instruments are often assumed perfectly targeted, fully offsetting financial shocks, and immune to time inconsistency and political economy problems. These assumptions limit applicability to real-world settings.
- Practical complications include imperfectly functioning policies, limited quantitative knowledge of tool effects, institutional constraints, and political economy concerns, which can increase coordination needs and shift burdens between policies.

_Experiences referenced: Brazil, Israel, Korea, Poland, Sweden, Turkey, United States (case evidence summarized)._

*Source: IMF chapter section text.*

### A. Imperfect macroprudential policies — key findings
- Financial stability concerns are difficult to identify and measure in practice; distinguishing efficient market responses from inefficient ones caused by market failures or externalities is challenging.
- Balancing Type I (too little emphasis on financial stability) and Type II (too much control or too often “crying wolf”) errors is a core difficulty for macroprudential policy use.
- Limited quantitative knowledge makes calibration hard:
  - Determining how large a buffer to build in booms and when/how much to release during stress is unresolved.
  - Some suggested macroprudential tools have never been tried in practice.
  - Interactions among different distortions and tools are not well understood; addressing one distortion may improve or worsen others.
- Existing models often:
  - Lack a rich description of crisis causes and non-linearities.
  - Assume macroprudential tools work perfectly and are fully effective in containing systemic risk, which is unrealistic.
- Practical experience with combined monetary and macroprudential policy is limited; few countries have clearly articulated and communicated joint objectives.
- Misjudging the effect of macroprudential tools on output can create policy errors (example: overestimating reserve requirements’ dampening of demand may lead to too small an interest-rate response).
- Institutional constraints can impede deployment:
  - Legal/institutional limits on tool access or cooperation with microprudential agencies.
  - Accounting issues (for example, dynamic provisioning vs. international financial reporting standards).
  - Need for fiscal authority participation for time-varying levies or tax treatment; legal changes may be required.
  - Macroprudential authorities may lack expertise or information to identify and calibrate risks.
- Costs of imperfect application:
  - Imperfect targeting or excessive tightness can worsen distortions or drive vulnerabilities outside the regulatory perimeter.
- Consequence for monetary policy:
  - Weak macroprudential application makes it more likely monetary policy must respond to financial conditions (e.g., by “leaning” against the credit cycle).
  - Monetary authorities should monitor broader financial indicators: buoyant credit growth, increasing leverage, and other financial indicators, and adapt policy horizons.

### B. Constraints on monetary policy — key findings and scenarios
- When monetary policy is constrained, demands on macroprudential policy increase:
  - Constraints include currency pegs, membership in a currency union, or limited monetary autonomy.
  - In such cases, macroprudential tools must address adverse side-effects of monetary policy on financial stability (for example, incentives for risk-taking).
- Macroprudential policy should not be overburdened; it needs strong fiscal and structural policy complements.
- Coordination across countries in a currency union is desirable (coordinated, not necessarily harmonized), reflecting different national financial conditions.
- Where monetary policy lacks credibility or effectiveness, macroprudential policy is not an optimal substitute:
  - Strengthening monetary policy effectiveness yields greater benefits than relying on imperfect macroprudential substitutes.
  - Example risk: credible pegs encouraging foreign currency borrowing that are costly to contain via macroprudential measures.

Box 4 — Small open economies (summary)
- Capital flows influenced by domestic/global policy rate differentials can fuel credit growth, leverage, and maturity/currency mismatches.
- Targeted macroprudential measures can change flow composition and reduce systemic risk (examples: levy on non-core FX liabilities in Korea; higher risk weights, tighter LTV ratios, limits on FX lending in some CESEE countries).
- A combination of capital and reserve requirement increases can control credit surges associated with capital flows, complementing policy-rate changes and enhancing policy autonomy (example: Brazil).
- Use of targeted macroprudential measures aligns with the IMF’s institutional view on managing capital flows; such frameworks help reap benefits of capital mobility while mitigating potential costs.

### C. Institutional and political economy considerations — implications
- Institutional and political economy constraints can generate coordination issues and time inconsistency problems, complicating policy design and implementation.
- Many empirical analyses of macroprudential effects face endogeneity problems; however, when focusing on real aggregate effects, bias may be lessened because macroprudential policies typically respond to credit and asset prices rather than to output.
- Where macroprudential policy is absent or weak, optimal monetary policy models suggest responding to financial conditions in addition to inflation and output gaps.
- The relative weight monetary policy should assign to financial stability is uncertain:
  - Cross-country evidence: at a five-year horizon a 100 basis point hike in the policy rate would reduce annual house price appreciation by only 1 percentage point, compared to a historical average annual increase of 5 percent, but would reduce GDP growth by 0.3 percentage points.
  - Historical episodes (Japan late 1980s, United States late 1920s) illustrate high economic costs of using monetary policy to prick asset bubbles.
- Monetary policy will often need to respond to financial turmoil:
  - It may need to be loosened to counter deflationary pressures while stabilizing the financial system.
  - Combining ex-ante regulation with ex-post monetary intervention can be desirable; ex-post monetary policy requires crisis management tools (lender of last resort, resolution and restructuring).

### Policy implications and recommendations (from text)
- Recognize country-specific circumstances when designing interactions between monetary and macroprudential policies.
- Strengthen quantitative analysis and country-specific work to better calibrate macroprudential tools and understand their interactions.
- Ensure macroprudential authorities have access to a broad set of tools, adequate legal/institutional frameworks, data, and expertise; involve fiscal authorities where necessary.
- Avoid overburdening macroprudential policy where monetary policy constraints exist; complement with fiscal and structural policies.
- Where macroprudential tools are imperfect, monetary policy should monitor financial indicators and be prepared to respond to financial conditions to support stability.
- Prioritize strengthening monetary policy frameworks and credibility rather than substituting them with macroprudential measures when monetary effectiveness is weak.

*International Monetary Fund — excerpt from chapter on the interaction of monetary and macroprudential policies.*

### 43.      Institutional constraints can lead to complex coordination issues. A parallel with

### _012913 - 43.      Institutional constraints can lead to complex coordination issues. A parallel with

### Institutional constraints and coordination issues
- Institutional constraints can generate complex coordination problems, analogous to monetary-fiscal interactions where distortions from fiscal policy (Dixit and Lambertini, 2003) or time-inconsistency problems from political factors (Barro and Gordon, 1983) create coordination challenges.
- Examples of coordination frictions:
  - A microprudential regulator in charge of macroprudential policies may tighten regulation in a recession.
  - Macroprudential policies may be imperfect for reasons discussed earlier in the source, producing suboptimal outcomes under separation versus joint decision-making.
  - Different institutions can hold fundamentally different views of the economy and financial system, reducing effective coordination.
- Political economy constraints:
  - A macroprudential regulator without sufficient political independence may be reluctant to constrain credit—even if socially optimal—because it can be politically unpopular and reduce tax revenues in the short run. 29
  - Frequency of macroprudential policy use can be limited when broad approval is required to reset an instrument or where instruments have strong distributional implications. 30
- Implication: Monetary policy will retain a residual role in assuring financial stability when macroprudential institutions or policies are constrained.

### Legal mandate, accountability, and communication
- Required institutional elements:
  - A strong legal mandate and appropriate powers.
  - Dedicated decision-making structures.
  - Accountability and communication tools.
- Legal framework functions:
  - Allow the policymaker to set out a policy strategy.
  - Establish transparency on deliberations leading to decisions.
  - Provide for ultimate accountability to legislators and the public. (IMF 2012a)
- Communications policy is needed to provide clarity to market participants and the public on objectives and actions of policymakers. 31

### Role of the central bank and safeguards
- Advantages of a leading central bank role in macroprudential policy:
  - Leverage central bank expertise in financial and macroeconomic analysis.
  - Share data and analyses across policy fields.
  - Facilitate analysis of side effects of each policy.
  - Potentially shield macroprudential function from political influence.
- Risks of assigning dual objectives to the central bank:
  - Temptation to use inflation to repair private balance sheets after financial shocks, causing welfare loss (Ueda and Valencia, 2012).
  - Time-consistency conflicts, lower credibility, reputational risks.
  - Communication challenges that may reduce monetary policy transparency. 32
- Recommended safeguards when both functions are housed in the central bank:
  - Separate decision-making structures (e.g., separate policy committees as in the United Kingdom).
  - Separate accountability and communications structures (e.g., separate reports to the legislature).
  - Legislative clarification of governance and primary objectives.
- These issues to be addressed in upcoming staff papers.

### Macroprudential function outside the central bank
- When macroprudential authority is outside the central bank:
  - The central bank can still play a leading role (for example, by chairing the committee).
  - Constitutional or other constraints may limit central bank participation (e.g., when the committee is chaired by the Treasury). 33
  - Constitutional constraints can rule out formal powers over tools typically assigned to the central bank (reserve requirements, payment and settlement oversight, foreign exchange market regulation).
  - When the central bank conducts microprudential supervision, an external macroprudential body may lack authority to recommend supervisory tool use (current proposals in the Netherlands cited).
- These constraints can limit coordination and the effectiveness of macroprudential policies.

### Interactions with other policies
- Additional coordination challenges:
  - Macroprudential and microprudential policies may conflict; resolution depends on institutional location of microprudential supervision.
  - Boundary between macroprudential policies and crisis management raises coordination issues.
  - Need for coordination with the fiscal authority can arise.
- Further discussion planned in future work (including the upcoming Board paper on “Key Aspects of Macroprudential Policy”).

### Conclusions and research gaps
- Crisis-driven paradigm shift:
  - Monetary policy is not well suited for assuring financial stability; macroprudential tools should address distortions leading to systemic risk.
  - Well-calibrated and clearly communicated macroprudential policies can contain risks ex-ante, help buffer shocks, and ease monetary policy during financial stress.
  - Monetary policy can affect financial stability, but if both policies perfectly attain their objectives, side effects pose limited challenges.
- When policies do not operate perfectly:
  - Interactions between macroprudential and monetary policies become important.
  - With weaknesses in macroprudential application, monetary policy may need to “lean” against the credit cycle and at times be expansionary after negative financial shocks.
  - Where national monetary policy is constrained (e.g., currency unions), demands on macroprudential policy increase, requiring cross-country coordination.
  - Few cases where macroprudential policies optimally substitute for weak monetary policy.
- Institutional framework prescriptions:
  - Safeguards are required when dual objectives are assigned to one agency.
  - Distinguish policy functions with separate decision-making, accountability, and communication structures.
  - Different issues arise when macroprudential function is established outside the central bank.
- Areas needing further work:
  - Effectiveness of macroprudential policies compared with monetary policy.
  - Operationalization of macroprudential policies and understanding their transmission in upturns and downturns.
  - Interaction with microprudential, crisis management, and fiscal policies.

### Annex summaries (selected)
- Annex I: During the Great Moderation, monetary policy focused on price stability left systemic financial risks largely unaddressed; output gaps and inflation were relatively flat for countries that later experienced crises (Ireland, Spain, United States). Credit and asset prices rose rapidly, producing distortions in output composition and amplifying systemic risk effects when realized.
- Annex II: Literature on channels through which monetary policy can affect financial stability outlines:
  - Borrower balance sheet (default) channel, with evidence including Jiménez et al (2009) and Sengupta (2010).
  - Risk-taking channel, with references to Borio and Zhu (2008), Valencia (2011), Dell’Ariccia and others (2010), Adrian and Shin (2012).
  - Risk-shifting channel, with evidence from Gan (2004) and Landier and others (2011).
  - Asset price channel, with mixed evidence and references including Del Negro and Otrok (2007) and IMF (2009).
  - Exchange rate channel, with capital flow and carry-trade effects documented (Hahm and others, 2012; Merrouche and Nier, 2010) and country examples (Brazil, Peru, Turkey, Iceland). 

*International Monetary Fund — “THE INTERACTION OF MONETARY AND MACROPRUDENTIAL POLICIES” (excerpt).*

### 6. The table overleaf shows, for each channel, what theory predicts for the effects of

### 6. The table overleaf shows, for each channel, what theory predicts for the effects of changes in the monetary policy stance on financial stability, and summarizes related empirical evidence.

### Annex Table 1. Monetary Policy Effects on Financial Stability
- Columns (as presented):
  - Sources of Financial Instability
  - Channel
  - Predicted Effect (   improves stability)
    - ↓r  ↑r 
  - Selected Empirical Evidence

- Borrowing Constraints — Balance Sheet (default) Channel
  - Predicted Effect (as shown): ↑r ,    ↑r ,    ↑r ,    ↑r ,    
  - Selected Empirical Evidence:
    - Sengupta (2010)
    - Jiménez and others (2009)
    - Gertler and Gilchrist (1994)
    - Asea and Blomberg (1998)

- Risky Behavior of Financial Institutions — Risk-taking Channel
  - Predicted Effect (as shown): ↓r ,    ↓r ,    X
  - Selected Empirical Evidence:
    - Jiménez and others (2009)
    - Ioannidou and others (2009)
    - Merrouche and Nier (2010)

- Risk-shifting Channel
  - Predicted Effect (as shown): ↑r ,    ↑r ,    
  - Selected Empirical Evidence:
    - Gan (2004)
    - Landier and others (2011)

- Externalities through Aggregate Prices — Asset price Channel
  - Predicted Effect (as shown): ↓r ,  ↓r ,  X
  - Selected Empirical Evidence:
    - Altunbas and others (2012)
    - Del Negro and Otrok (2007)
    - IMF (2009)

- Exchange rate Channel
  - Predicted Effect (as shown): ↑r ,    ↑r ,    ↑r ,    
  - Selected Empirical Evidence:
    - Hahm and others (2012)
    - Merrouche and Nier (2010)
    - Jonsson (2009)

- Source: IMF
- Notes (verbatim as in source):
  - r means a↓ decrease of policy rates,     r means a↑n increase of policy rates, “  ” means a decline instability, “  ” an improvement, and “X” no statistically significant effect.

### Key implications (implied by the table and empirical citations)
- Different monetary policy channels have heterogeneous predicted effects on financial stability:
  - Lower policy rates (↓r) are associated with improvements in stability through some channels (e.g., balance sheet/borrowing-constraints, asset-price channel in some cases) but with deteriorations via risk-taking channels.
  - Higher policy rates (↑r) are associated with improvements in stability via some channels (e.g., balance sheet/default and exchange-rate channels) and with mixed or insignificant effects in others.
- Empirical studies cited provide mixed evidence across channels, highlighting:
  - Robust empirical links between monetary policy and balance-sheet effects (Sengupta; Jiménez et al.; Gertler and Gilchrist; Asea and Blomberg).
  - Evidence consistent with a risk-taking channel (Jiménez et al.; Ioannidou et al.; Merrouche and Nier) but with some non-significant findings.
  - Evidence for asset-price and exchange-rate channels with varying signs depending on context and study.

### References (selected citations as listed in the source)
- Sengupta (2010)
- Jiménez and others (2009)
- Gertler and Gilchrist (1994)
- Asea and Blomberg (1998)
- Ioannidou and others (2009)
- Merrouche and Nier (2010)
- Gan (2004)
- Landier and others (2011)
- Altunbas and others (2012)
- Del Negro and Otrok (2007)
- IMF (2009)
- Hahm and others (2012)
- Jonsson (2009)

*Source: INTERNATIONAL MONETARY FUND — THE INTERACTION OF MONETARY AND MACROPRUDENTIAL POLICIES (Annex Table 1 as presented in the supplied content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2013/_012913.pdf_