## _sdn1303 - EXECUTIVE SUMMARY

## Source details

**Canonical URL:** [_sdn1303 - EXECUTIVE SUMMARY](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1303.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1303.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1303.pdf.json)

---

### Introduction
- The 2008–09 global economic and financial crisis:
  - Undermined the prevailing consensus on macroeconomic policy design.
  - Highlighted dangers from financial-sector imbalances, limits of monetary policy, and uncertainty about safe public-debt levels.
- Five years after the crisis began, a new macroeconomic policy consensus remains unclear, despite theoretical and empirical progress.
- Scope:
  - Focuses on policy design after the economy emerges from the crisis (not immediate exit measures).
  - Concentrates on the cyclical component of financial regulation; excludes broad structural reforms and overall financial regulation.
- Organization: monetary policy; fiscal policy; macroprudential policies.

### Monetary policy
- Overarching theme:
  - Movement from “one target, one instrument” (inflation rate and policy rate) toward “more targets, more instruments.”
  - Choice of targets and instruments remains controversial.

- Should central banks explicitly target activity?
  - Precrisis: “divine coincidence” — stabilizing inflation keeps output near potential.
  - Postcrisis: large output declines and higher unemployment did not produce expected inflation declines in most advanced economies.
  - Two interpretations:
    - Potential output fell nearly as much as actual output (small output gap); or
    - The relation between inflation and the output gap has weakened.
  - Evidence:
    - Most estimates indicate advanced economies still suffer from a substantial output gap.
    - Changed inflation–output relation attributed to more stable inflation expectations and a weaker relation (in magnitude and statistical significance) between the output gap and inflation for a given expected inflation rate.
  - Policy implication:
    - If the weakened relation persists, central banks may need to target activity more explicitly.

- Should central banks target financial stability?
  - Inflation and output stability alone are insufficient; sectoral imbalances and financial risks can build beneath apparent macro stability.
  - Policy-rate is a blunt tool; consensus is emerging that targeted macroprudential tools are preferable.
  - Caveats on macroprudential tools:
    - New, mixed evidence on effectiveness.
    - Vulnerable to circumvention and political economy constraints.
    - Governance and interaction with other policies unresolved.
  - Lean-versus-clean debate:
    - Given high costs of inaction, central banks may accept higher type I errors (acting as if a bubble) to reduce type II errors, but thresholds are hard to set.
    - Focus could be on asset-price booms funded through bank credit.

- Should central banks care about the exchange rate?
  - Volatile capital flows can harm macro and financial stability, especially in emerging markets with shallow financial markets or foreign-denominated liabilities.
  - Feasibility:
    - Sterilized intervention unlikely effective in integrated financial markets.
    - Extended inflation targeting with FX intervention may be feasible where financial frictions and segmentation exist.
  - Desirability:
    - Intervention resisting trend appreciation driven by fundamentals is typically not desirable and problematic multilaterally.

- How should central banks deal with the zero bound?
  - Distinguishes liquidity trap (policy-rate constrained) and financial-market segmentation.
  - Distinction between targeted easing (asset-specific purchases without changing money supply) and quantitative easing (unsterilized increases in money supply).
  - Evidence:
    - Targeted easing affected prices of acquired assets where segmentation was acute (e.g., U.S. mortgage-backed securities in 2008–09).
    - Quantitative easing works via expectations of low future nominal rates or higher future inflation; evidence is mixed.
    - Forward guidance affected long-term rates significantly in Canada and the United States, less so in Sweden.
  - Alternative rules reconsidered: price-level targeting and nominal-GDP targeting; level-based rules allow higher inflation now but have shortcomings.
  - Forward guidance likely to remain part of policy away from the zero bound.

- To whom should central banks provide liquidity?
  - Crisis extended multiple-equilibrium logic to wholesale funding, nonbank intermediaries, and sovereigns.
  - Issues with extending liquidity beyond banks:
    - Distinguishing illiquidity from insolvency is harder for unregulated entities.
    - Moral hazard: expectation of liquidity provision incentivizes accumulation of less liquid portfolios (Farhi and Tirole, 2012).
    - Haircuts and conditionality can mitigate but not eliminate moral hazard; “unlimited liquidity” needs during systemic crises undermine enforceability in tranquil times.

### Fiscal policy
- Crisis response and debt dynamics:
  - Early fiscal stimulus occurred while monetary policy was constrained.
  - Large increases in public debt followed, largely driven by revenue declines.

- What are the dangers of high public debt?
  - Precrisis median debt-to-GDP in advanced economies: about 60 percent.
  - By end-2012, median debt-to-GDP in advanced economies was close to 100 percent and still increasing.
  - Examples of contingent-liability-driven increases:
    - Ireland and Iceland increases of 25 and 43 percentage points.
    - Portugal increase of about 15 percentage points due to state-owned enterprise losses and called guarantees.
  - Lessons:
    - Macroeconomic shocks and induced deficits can be larger than previously considered possible.
    - Official debt ratios can hide contingent liabilities unknown to investors and sometimes to governments.
    - Need for more comprehensive debt measures and lower prudent debt-to-GDP thresholds.
  - Multiple-equilibria risk:
    - High debt raises the likelihood that investor concerns increase interest rates, making default more likely.
    - Risks increase with short debt maturities and large rollover needs.
    - Central banks can, in principle, eliminate bad equilibria by providing liquidity, but practical complications exist.
    - Empirical illustrations: ECB intervention reduced bad-equilibrium risk for Spain and Italy; benign rates for Belgium, the United States, and Japan reflect safe-haven perceptions that are potentially fragile.

- How to deal with the risk of fiscal dominance?
  - Debt restructuring is costly and limited in advanced economies because much debt is domestically held (more than 90 percent in Japan).
  - Monetary policy levers:
    - Prolong quantitative-easing holdings of sovereign bonds.
    - Delay nominal-rate increases and accept higher inflation to reduce real interest rates.
  - Historical precedent: rapid inflation reduced debt in postwar U.S.; concerns about financial repression resurfaced (Reinhart and Sbrancia, 2011).
  - Illustrative quantitative example:
    - IMF staff simulations: if inflation increased from the current average projected pace of less than 2 percent to, say, 6 percent, net debt ratio would decline, after five years, by about 10 percent of GDP on average for the G7 (Akitoby, Komatsuzaki, and Binder, forthcoming).
    - Effect larger if central banks maintain lower real interest rates for some time.
  - Costs and risks:
    - Higher inflation and lower real rates produce distributional and political consequences; possible shifts to foreign assets, depreciation, and further inflation.
  - Governance recommendation:
    - Monetary policy decisions should remain the sole purview of central banks, free from political interference.
    - Central banks should base decisions on impacts on inflation, output, and financial stability and avoid slipping into fiscal dominance.
    - Fiscal dominance risk seems relatively limited in the euro area but more relevant elsewhere and could persist for years.

- At what rate should public debt be reduced?
  - Identifying fiscal policy effects on output is difficult (state dependence, composition, expectations, monetary policy response).
  - Evidence:
    - Precrisis fiscal multipliers varied widely.
    - Newer evidence suggests multipliers have been larger than in normal times, especially at the start of the crisis (Blanchard and Leigh, 2013), with little evidence of confidence effects (Perotti, 2011).
  - Trade-offs:
    - Short-run growth costs of faster consolidation versus reduced long-run risk from lower debt.
    - Market pressures often constrain speed of consolidation; cross-country variation partly explained by sovereign bond yields.
    - Multiple-equilibria risks and investor behavior add uncertainty.
  - Policy design principles:
    - Embed consolidation in a credible medium-term plan to reassure investors and the public.
    - Introduce early reforms that tackle age-related expenditure pressures without reducing near-term aggregate demand (for example, increases in retirement age).
    - Renew interest in fiscal rules and medium-term plans with mechanisms to deal with shocks (multiyear spending limits, exclusions, or cyclically adjusted targets).

- Can we do better than automatic stabilizers?
  - Letting automatic stabilizers operate is preferred to constraining them, but they may not deliver optimal cyclical responses.
  - Limitations:
    - Assume output movements are temporary.
    - Strength varies across countries based on tax/expenditure structures and government size.
  - Proposal:
    - Design better stabilizers (e.g., cyclical investment tax credits, pre-legislated tax cuts triggered by indicators).
  - Implementation: little analytical exploration and essentially no operational uptake to date (McKay and Reis, 2012 an exception).

### Macroprudential instruments
- Motivation:
  - Crisis showed sectoral booms and vulnerabilities (excess leverage, household indebtedness, maturity mismatches, off-balance-sheet tail risks) can build under apparently stable macro conditions.
  - Imbalances generate highly nonlinear costs: gradual buildups followed by abrupt busts with major welfare costs.
  - Monetary and fiscal policies are imperfect for addressing cyclical financial imbalances; targeted macroprudential instruments gained interest.

- Combining macroprudential and microprudential regulation
  - Microprudential regulation is partial-equilibrium and does not capture interconnections or systemic state dependence.
  - Implication: alignment of micro- and macroprudential functions is desirable—possibly under the same roof—but political economy concerns may favor separation.
  - Rationale for independence:
    - Macroprudential actions (e.g., leaning against credit booms) are potentially unpopular and akin to monetary policy tasks; independence may improve credibility.
  - Operational model example:
    - UK: Financial Policy Committee (macroprudential) can vary capital ratios applied by microprudential regulators.

- Macroprudential tools: categories and functioning
  - Three broad categories:
    1. Tools influencing lenders’ behavior (cyclical capital requirements, leverage ratios, dynamic provisioning).
    2. Tools influencing borrowers’ behavior (loan-to-value ratios (LTVs), debt-to-income ratios (DTIs)).
    3. Capital flow management tools.
  - Cyclical capital ratios and dynamic provisioning:
    - Logic: build buffers in good times to absorb losses in bad times, smooth booms, limit credit growth, and reduce fiscal costs of crises.
    - Practical challenges:
      - Regulatory perimeter circumvention (nonbanks, foreign banks, off-balance-sheet activities).
      - Choice of cyclicality basis (economic cycle, credit growth, asset prices).
      - Procyclicality limited if banks hold capital well above regulatory minimums.
      - Time consistency and political difficulty in reducing requirements in busts.
    - Evidence: mixed. These tools have not typically stopped credit/real-estate booms but sometimes curbed particular loan groups (e.g., FX loans) and provided buffers reducing fiscal costs (Saurina, 2009; Crowe and others, 2011; Dell’Ariccia and others, 2012).
  - Loan-to-value and debt-to-income ratios:
    - Aim to prevent borrower-side vulnerabilities; can reduce bankruptcies/foreclosures and attenuate macro busts.
    - Implementation issues:
      - Hard to apply beyond households.
      - Circumvention and risk-shifting (second liens, nonbank credit expansion, foreign bank lending, FX denomination).
      - Potential complications for small-business financing using housing wealth as collateral.
    - Evidence: promising — LTV and DTI limits during rapid house-price rises appear to reduce credit booms and lower probability of financial distress and subpar growth after booms (Crowe and others, 2011; Dell’Ariccia and others, 2012).
  - Capital flow management tools:
    - Aim at risks from volatile capital flows.
    - If macro policies are appropriate and flows harm stability, controls can be appropriate, typically alongside other macroprudential tools (Ostry and others, 2010; IMF, 2012b).
    - Relationship with FX intervention:
      - Complements: controls reduce elasticity of flows to returns, making intervention more powerful.
      - Substitutes: both can affect the exchange rate.
    - Advantages and limits:
      - Can be targeted to specific flows but vulnerable to circumvention via relabeling.
    - Evidence: abundant but inconclusive (Ostry and others, 2010).
  - Overarching assessment:
    - Macroprudential tools offer a promising additional lever to curb booms and contain imbalances.
    - Evidence of effectiveness is mixed; circumvention, political-economy constraints, governance design, and interactions with other policies remain unresolved.
    - We are a long way from reliably knowing how to deploy these tools across varied institutional and financial structures.

### How to combine monetary and macroprudential policies
- Interaction channels:
  - Low policy rates can encourage excessive risk taking in financial markets.
  - Macroprudential tools affect aggregate demand via credit costs.
- Theoretical ideal:
  - If both policies worked perfectly, allocate macroeconomic stability to monetary authority and financial stability to macroprudential authority; monetary policy could offset aggregate-demand declines from macroprudential tightening.
- Practical limitations:
  - Imperfect tools mean one policy cannot be blind to the limitations of the other.
  - When macroprudential tools work poorly, monetary policy must consider financial stability.
  - Under currency unions or exchange rate pegs, where monetary policy cannot address the cycle, macroprudential tools must contribute to aggregate demand management (see IMF, 2012c).
- Coordination problems:
  - Separate authorities will typically not reach the first-best solution because each prioritizes its own objective.
  - Example adverse spiral:
    - In recession: central bank cuts policy rate to stimulate demand; financial authority tightens macroprudential regulation to counter risk taking; central bank cuts rates further anticipating contraction—resulting in rates too low and macroprudential measures too tight relative to a coordinated solution.

### Institutional design: consolidation versus separation
- Theoretical solution: consolidation—put monetary, microprudential, and macroprudential roles under one roof—probably preferable.
  - Central bank in charge of prudential tools gains useful information for monetary policy.
- Costs and trade-offs of consolidation:
  1. Communication and credibility:
     - Dual mandate may make it harder to anchor inflation expectations when fighting inflation conflicts with financial-stability objectives.
     - Earlier arguments supported moving prudential supervision out of central banks to financial stability authorities for this reason.
  2. Political economy and accountability:
     - Macroprudential objectives are murkier and harder to measure (credit growth, leverage, asset price growth).
     - Difficulty defining financial stability and identifying its desirable level.
     - Targeted macroprudential tools invite focused political opposition (example: young households opposing lower maximum LTV).
     - Independence of macroprudential policy is on weaker ground; political interference could undermine monetary policy independence.
- Institutional example: the United Kingdom may offer a model with both monetary and financial stability committees within the Bank of England.

### Final assessment and policy outlook
- Despite research progress and policy experimentation, contours of future macroeconomic policy remain vague.
- Relative roles of monetary policy, fiscal policy, and macroprudential policy are still evolving.
- Two alternative emerging structures:
  - Less ambitious extreme:
    - Return to flexible inflation targeting.
    - Little fiscal policy use for macroeconomic stability.
    - Limited use of macroprudential instruments due to difficulty or political cost.
  - More ambitious extreme:
    - Central banks with broad macroeconomic and financial stability mandates.
    - Use of many monetary and macroprudential instruments.
    - More active fiscal policy use.
- Likely path forward: experimentation with learning pains and gradual improvement over time.

*Source: _sdn1303 - EXECUTIVE SUMMARY*

### Executive Summary ......................................................................................................

### Executive Summary

### I. Introduction
- "Introduction ............................................................................................................................4"

### II. Monetary policy
- "Monetary policy ....................................................................................................................4"
- A. "Should Central Banks Explicitly Target Activity? ...................................................5"
- B. "Should Central Banks Target Financial Stability? ....................................................6"
- C. "Should Central Banks Care about the Exchange Rate? .............................................7"
- D. "How Should Central Banks Deal with the Zero Bound? ..........................................8"
- E. "To Whom Should Central Banks Provide Liquidity? ..............................................10"

### III. Fiscal policy
- "Fiscal policy .......................................................................................................................11"
- A. "What Are the Dangers of High Public Debt? ..........................................................11"
- B. "How to Deal with the Risk of Fiscal Dominance? ..................................................13"
- C. "At What Rate Should Public Debt Be Reduced? ....................................................15"
- D. "Can We Do Better Than Automatic Stabilizers? ....................................................16"

### IV. Macroprudential instruments
- "Macroprudential instruments .............................................................................................17"
- A. "How to Combine Macroprudential Policy and Microprudential Regulation? ........18"
- B. "What Macroprudential Tools Do We Have and How Do They Work? ..................18"
- C. "How to Combine Monetary and Macroprudential Policies? ...................................20"

### V. Conclusions
- "Conclusions .........................................................................................................................22"

- "References ................................................................................................................................23"

*Source: _sdn1303 - Executive Summary ......................................................................................................*

### EXECUTIVE SUMMARY

### _sdn1303 - EXECUTIVE SUMMARY

### Introduction
- The 2008–09 global economic and financial crisis:
  - Undermined the prevailing consensus on macroeconomic policy design.
  - Highlighted dangers from financial-sector imbalances, limits of monetary policy, and uncertainty about safe public-debt levels.
  - Prompted reassessment spanning technical points to institutional design.
- Five years after the crisis began, a new macroeconomic policy consensus remains unclear, though theoretical and empirical progress has been made.
- Scope of analysis:
  - Focuses on the design of macroeconomic policy after the economy emerges from the crisis (not on immediate exit measures).
  - Takes a relatively narrow view of macro policy, excluding broad structural reforms and overall financial regulation; concentrates on the cyclical component of financial regulation.
- Paper organization: monetary policy; fiscal policy; macroprudential policies.

### Monetary policy
- General theme:
  - Movement from “one target, one instrument” (inflation rate and policy rate) toward “more targets, more instruments.”
  - Choice of targets and instruments remains controversial.

- Should central banks explicitly target activity?
  - Precrisis rationale: “divine coincidence” — stabilizing inflation would keep output near potential.
  - Postcrisis observation: large declines in output and higher unemployment did not produce the expected fall in inflation in most advanced economies.
  - Two logical interpretations:
    - Potential output fell nearly as much as actual output, so output gap is small; or
    - The relation between inflation and the output gap has weakened.
  - Evidence:
    - Most estimates indicate advanced economies still suffer from a substantial output gap.
    - Recent work (e.g., WEO, 2013) attributes the changed inflation–output relation to:
      - More stable inflation expectations (increasing monetary credibility).
      - A weaker relation (in magnitude and statistical significance) between the output gap and inflation for a given expected inflation rate.
  - Policy implication:
    - If the weakened relation persists, central banks may need to target activity more explicitly.

- Should central banks target financial stability?
  - Inflation and output stability alone are insufficient; sectoral imbalances and financial risks can build beneath apparent macro stability.
  - Policy-rate is a blunt tool for addressing these imbalances; consensus is emerging that targeted macroprudential tools are preferable.
  - Caveats about macroprudential tools:
    - New, with mixed evidence on effectiveness.
    - Vulnerable to circumvention and political economy constraints.
    - Governance and interaction with other policies remain unresolved.
  - Lean-versus-clean debate revived: given high costs of inaction, central banks may accept higher type I errors (acting as if a bubble) to reduce type II errors, but setting thresholds is difficult; focus could be on asset-price booms funded through bank credit.

- Should central banks care about the exchange rate?
  - Volatile capital flows can harm macro and financial stability, especially in emerging markets with shallow financial markets or foreign-denominated liabilities.
  - Considerations:
    - Feasibility: For economies with integrated financial markets, sterilized intervention is unlikely to be effective; for economies with financial frictions and segmented markets, extended inflation targeting with FX intervention may be feasible.
    - Desirability: Intervention is typically not desirable when resisting trend appreciation driven by fundamentals; intervention aimed at resisting fundamentals is problematic, and may not be acceptable multilaterally.

- How should central banks deal with the zero bound?
  - Two distinct crisis characteristics: liquidity trap (policy-rate constrained) and segmentation of financial markets.
  - Distinction between targeted easing (purchases of specific assets without changing money supply) and quantitative easing (unsterilized increases in money supply).
  - Empirical evidence:
    - Targeted easing affected prices of assets acquired, particularly where market segmentation was acute (e.g., U.S. mortgage-backed securities in 2008–09).
    - Quantitative easing’s monetary-expansion component works via expectations of low future nominal rates or higher future inflation; evidence is mixed.
    - Forward guidance has had significant impact on long-term rates in Canada and the United States, less so in Sweden’s Riksbank.
  - Discussion of alternative rules:
    - Price-level targeting and nominal-GDP targeting are reconsidered; level-based rules allow higher inflation now but have shortcomings (e.g., temporary price shocks are not treated as bygones).
  - Forward guidance is likely to remain part of future monetary policy away from the zero bound.

- To whom should central banks provide liquidity?
  - Crisis showed multiple-equilibrium logic applies beyond deposit-taking banks to wholesale funding, nonbank intermediaries, and sovereigns.
  - Central banks extended liquidity to non-deposit-taking institutions and indirectly to sovereigns.
  - Issues arising from liquidity provision beyond banks:
    - Distinguishing illiquidity from insolvency is harder for unregulated entities with limited information.
    - Moral hazard: expectation of liquidity provision incentivizes accumulation of less liquid portfolios (Farhi and Tirole, 2012).
    - Haircuts and conditionality can mitigate but not eliminate moral hazard; “unlimited liquidity” needed during systemic crises undermines enforceability in tranquil times.

### Fiscal policy
- Early crisis response: fiscal stimulus when monetary policy was constrained; subsequent large increases in public debt (largely driven by revenue declines).
- Two main conclusions from earlier work:
  - Safe levels of public debt before the crisis were not as safe as thought.
  - Fiscal policy’s precrisis limited cyclical role should be revisited.

- Key policy issue: optimal speed of fiscal consolidation depends on:
  - How harmful current debt levels are (including risk of multiple equilibria).
  - Short-run growth effects of consolidation given the state of the economy and composition/path of adjustment.

- What are the dangers of high public debt?
  - Precrisis median debt-to-GDP in advanced economies: about 60 percent.
  - By end-2012, median debt-to-GDP in advanced economies was close to 100 percent and still increasing.
  - Sources of increase:
    - Sharp revenue falls from the recession.
    - Fiscal stimulus.
    - Realization of contingent liabilities (examples cited: Ireland and Iceland increases of 25 and 43 percentage points; Portugal increase of about 15 percentage points due to state-owned enterprise losses and called guarantees).
  - Lessons:
    - Macroeconomic shocks and induced deficits can be larger than previously considered possible.
    - Official debt ratios can hide contingent liabilities unknown to investors and sometimes to governments.
    - Need for more comprehensive debt measures and lower prudent debt-to-GDP thresholds.
  - Multiple equilibria risk:
    - High debt raises likelihood that investor concerns about default raise interest rates, making default more likely.
    - Risks increase with short debt maturities and large rollover needs.
    - Central banks can, in principle, eliminate a bad equilibrium by providing liquidity, but the scale of intervention, differentiation of illiquidity versus insolvency, and absence of state collateral complicate such interventions.
    - Empirical illustrations: ECB intervention reduced bad-equilibrium risk for Spain and Italy; benign rates for Belgium, the United States, and Japan reflect perceptions of safe-haven status but are potentially fragile.

- How to deal with the risk of fiscal dominance?
  - Debt restructuring is costly and cumbersome; scope in advanced economies is limited because much debt is domestically held (more than 90 percent in Japan).
  - Monetary policy can reduce debt burden by:
    - Prolonging quantitative-easing holdings of sovereign bonds.
    - Delaying nominal-rate increases and accepting higher inflation to reduce real interest rates.
  - Historical precedents: rapid inflation reduced debt postwar U.S.; Reinhart and Sbrancia (2011) discuss potential return to financial repression concerns.
  - Quantitative illustrative example:
    - IMF staff simulations: if inflation increased from the current average projected pace of less than 2 percent to, say, 6 percent, net debt ratio would decline, after five years, by about 10 percent of GDP on average for the G7 (Akitoby, Komatsuzaki, and Binder, forthcoming).
    - Effect would be larger if central banks can maintain lower real interest rates for some time.
  - Costs and risks:
    - Higher inflation and lower real rates are a less visible form of debt reduction with significant distributional and political consequences; possible shifts to foreign assets, depreciation, and further inflation.
  - Governance recommendation:
    - Monetary policy decisions should remain the sole purview of central banks, free from political interference.
    - Central banks should base decisions on impacts on inflation, output, and financial stability and be mindful of slipping into fiscal dominance.
    - Fiscal dominance risk:
      - Seems relatively limited in the euro area (no single government can force the ECB).
      - More relevant elsewhere and could persist for years.

- At what rate should public debt be reduced?
  - Identifying fiscal policy effects on output is difficult (state dependence, composition, expectations, monetary policy response).
  - Empirical evidence:
    - Precrisis fiscal multipliers varied widely.
    - Newer evidence suggests multipliers have been larger than in normal times, especially at the start of the crisis (Blanchard and Leigh, 2013), with little evidence of confidence effects (Perotti, 2011).
  - Speed of consolidation:
    - Often constrained by market pressures rather than purely policy choice; cross-country variation explained in part by sovereign bond yields.
    - Trade-off: short-run growth costs of faster consolidation versus reduced long-run risk from lower debt.
    - Multiple-equilibria risks and investor behavior add uncertainty; speed of consolidation will remain contested.
  - Policy design principles:
    - Consolidation should be embedded in a credible medium-term plan to reassure investors and the public.
    - Early introduction of reforms (e.g., increases in retirement age) that tackle age-related expenditure pressures without reducing near-term aggregate demand.
    - Renewed interest in fiscal rules and medium-term plans; include mechanisms to deal with shocks (multiyear spending limits, exclusion of cyclical/nondiscretionary/fiscally neutral items, or cyclically adjusted targets).

- Can we do better than automatic stabilizers?
  - Letting automatic stabilizers operate is preferred to constraining them, but they may not deliver optimal cyclical responses.
  - Limitations of automatic stabilizers:
    - They assume output movements are temporary.
    - Strength varies across countries based on tax/expenditure structures and government size.
  - Proposal: design better stabilizers (e.g., cyclical investment tax credits, pre-legislated tax cuts triggered by indicators).
  - Implementation: little analytical exploration and essentially no operational uptake to date (McKay and Reis, 2012 an exception).

### Macroprudential instruments
- Motivation:
  - Crisis showed that sectoral booms and vulnerabilities (excess leverage, household indebtedness, maturity mismatches, off-balance-sheet tail risks) can build under apparently stable macro conditions.
  - Imbalances generate highly nonlinear costs: gradual buildups followed by abrupt busts with major welfare costs.
  - Monetary and fiscal policies are imperfect for addressing such cyclical financial imbalances; targeted macroprudential instruments have gained interest.

- Conceptual challenges:
  - Articulation needed between macroprudential and microprudential regulation, and between macroprudential and monetary policy.
  - Macroprudential approaches must account for systemic interactions across institutions and the real economy.

- How to combine macroprudential policy and microprudential regulation?
  - Microprudential regulation is partial-equilibrium; does not capture interconnections or systemic state dependence.
  - Implication: micro- and macroprudential functions should be aligned — possibly under the same roof — but political economy concerns may favor separation.
  - Rationale for independence:
    - Macroprudential actions (e.g., leaning against credit booms) are potentially unpopular and akin to monetary policy tasks; independence may improve credibility.
  - Operational model example:
    - UK approach: Financial Policy Committee (macroprudential) can vary capital ratios applied by microprudential regulators.

- Macroprudential tools: categories and functioning
  - Three broad categories:
    1. Tools influencing lenders’ behavior (cyclical capital requirements, leverage ratios, dynamic provisioning).
    2. Tools influencing borrowers’ behavior (loan-to-value ratios (LTVs), debt-to-income ratios (DTIs)).
    3. Capital flow management tools.
  - Cyclical capital ratios and dynamic provisioning:
    - Logic: build buffers in good times to absorb losses in bad times, smooth booms, limit credit growth, and reduce fiscal costs of crises.
    - Practical implementation challenges:
      - Regulatory perimeter circumvention (nonbanks, foreign banks, off-balance-sheet activities).
      - Choice of cyclicality basis (economic cycle, credit growth, asset prices).
      - Procyclicality is limited if banks hold capital well above regulatory minimums.
      - Time consistency and political difficulty in allowing reduction of requirements in busts.
    - Evidence: mixed. Tighter capital requirements/dynamic provisioning have not typically stopped credit/real-estate booms, but have sometimes curbed particular loan groups (e.g., FX loans) and provided buffers that contained fiscal costs (Saurina, 2009; Crowe and others, 2011; Dell’Ariccia and others, 2012).
  - Loan-to-value and debt-to-income ratios:
    - Aim to prevent borrower-side vulnerabilities; can reduce bankruptcies/foreclosures and attenuate macro busts.
    - Implementation issues:
      - Hard to apply beyond households.
      - Circumvention costs and risk-shifting (second liens, nonbank credit expansion, foreign bank lending, FX denomination).
      - Potential complications for small-business financing using housing wealth as collateral.
    - Evidence: promising — LTV and DTI limits during rapid house-price rises appear to reduce credit booms and lower probability of financial distress and subpar growth after booms (Crowe and others, 2011; Dell’Ariccia and others, 2012).
  - Capital controls (capital flow management tools):
    - Aim at risks from volatile capital flows.
    - If macro policies are appropriate and flows harm stability, controls can be appropriate, typically alongside other macroprudential tools (Ostry and others, 2010; IMF, 2012b).
    - Relationship with FX intervention:
      - Complements: controls reduce elasticity of flows to returns, making intervention more powerful.
      - Substitutes: both can affect the exchange rate.
    - Advantages and limits:
      - Can be targeted to specific flows but are vulnerable to circumvention via relabeling.
    - Evidence: abundant but inconclusive (Ostry and others, 2010).

- Overarching assessment:
  - Macroprudential tools offer a promising additional policy lever to curb booms and contain imbalances.
  - However, evidence of effectiveness is mixed; circumvention, political economy constraints, governance design, and interactions with other policies remain key unresolved issues.
  - We are a long way from reliably knowing how to deploy these tools across different institutional and financial structures.

*Source: _sdn1303 - EXECUTIVE SUMMARY*

### conclusion is that controls affect the composition of flows but not their level; this, however,

### V. CONCLUSIONS

### Effects of capital controls on flows
- Conclusion drawn: "controls affect the composition of flows but not their level; this, however, seems unlikely, given the specialization of the different types of investors."
- If capital controls decrease short-term flows, they are unlikely to be replaced by long-term flows, one for one.
- First readings of Brazil’s experience with taxes on capital inflows during the current crisis are mixed:
  - Authorities varied both the tax rate and the perimeter of the tax over time.
  - Despite some circumvention, these measures "appear to have slowed down portfolio inflows and limited exchange rate appreciation."
  - Two views cited: Chamon and Garcia, 2013; and Jinjarak, Noy, and Zheng, 2012.

### How to combine monetary and macroprudential policies
- Interaction channels:
  - Low policy rates affect behavior in financial markets, leading to potentially excessive risk taking.
  - Macroprudential tools affect aggregate demand through their effects on the cost of credit.
- Theoretical ideal:
  - If both policies worked perfectly, macroeconomic stability could be allocated to the monetary authority and financial stability to the macroprudential authority.
  - Monetary policy could offset declines in aggregate demand from macroprudential tightening; macroprudential tools could be adjusted to offset excessive risk taking from monetary easing.
- Practical limitations:
  - Both tools work far less than perfectly; therefore, one policy cannot be blind to the limitations of the other.
  - To the extent macroprudential tools work poorly, monetary policy must take into account financial stability.
  - When monetary policy is unavailable to deal with a country’s cycle (as under a currency union or an exchange rate peg), macroprudential tools must contribute to the management of aggregate demand (see IMF, 2012c).
- Coordination problems between separate authorities:
  - Separate agencies (central bank for monetary policy; financial authority for macroprudential policy) will typically not coordinate on the first-best solution because each policymaker primarily cares about his or her own objective.
  - Potential adverse policy spiral example:
    - In a recession, the central bank may cut the policy rate aggressively to stimulate demand.
    - The financial authority, worried about relaxed monetary stance and risk taking, may tighten macroprudential regulation.
    - Anticipating contractionary effects, the central bank may cut rates even more aggressively.
    - Outcome: interest rates that are too low and macroprudential measures that are too tight relative to a coordinated solution.

### Institutional design: consolidation versus separation
- Obvious theoretical solution: consolidation—put everything under one roof—probably the preferable design.
  - Putting the central bank in charge of micro- and macroprudential tools gives it information useful for the conduct of monetary policy (see Coeure, 2013; Jácome, Nier, and Imam, 2012).
- Costs and trade-offs of consolidation:
  1. Communication and credibility issues:
     - If macroprudential tools work imperfectly, a central bank with a dual mandate will have a harder time convincing the public it will fight inflation and thus anchoring expectations when inflation fighting conflicts with the financial-stability objective.
     - This concern was part of earlier arguments for moving prudential supervision out of central banks to financial stability authorities.
  2. Political economy and accountability issues (potentially more critical):
     - Central bank independence was facilitated by a clear objective (inflation) and relatively simple operational tools (open market operations and a policy rate).
     - Macroprudential objectives are murkier and more difficult to measure due to:
       - Multidimensional intermediate targets: credit growth, leverage, asset price growth, and so on.
       - Challenges understanding the relationship between macroprudential objectives and the financial stability objective.
       - Difficulty defining financial stability and identifying its desirable level: a policy rate hike can be defended ex post by showing inflation near target, whereas macroprudential tightening that prevents a crisis can be attacked ex post as unnecessary.
       - Targeted nature of macroprudential tools implies potential for strong, focused political opposition (example given: young households objecting to a decrease in the maximum LTV).
     - Because of these features, the independence of macroprudential policy is on weaker ground.
     - Concern: political interference with macroprudential policy could undermine the independence of monetary policy.
  - Institutional example: the United Kingdom may be showing a model by having a monetary stability and a financial stability committee, both within the Bank of England.

### Final assessment and policy outlook
- Despite significant research progress and policy experimentation in the last two years, the contours of future macroeconomic policy remain vague.
- The relative roles of monetary policy, fiscal policy, and macroprudential policy are still evolving.
- Two alternative structures are emerging:
  - Less ambitious extreme:
    - A return to flexible inflation targeting.
    - Little use of fiscal policy for macroeconomic stability purposes.
    - Limited use of macroprudential instruments because they prove difficult or politically costly to use.
  - More ambitious extreme:
    - Central banks envisioned to have a broad macroeconomic and financial stability mandate.
    - Use of many monetary and macroprudential instruments.
    - More active use of fiscal policy tools.
- Likely path forward: experimentation with learning pains, with the expectation of more successful outcomes over time.

*Source: Excerpt from the supplied content unit.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1303.pdf_