Macroprudential regulation and the role of monetary policy

This paper examines the macroprudential roles of bank capital regulation and monetary policy in a Dynamic Stochastic General Equilibrium model with endogenous financial frictions and a borrowing cost channel. We identify various transmission channels through which credit risk, commercial bank losses, monetary policy and bank capital requirements affect the real economy. These mechanisms generate significant financial accelerator effects, thus providing a rationale for a macroprudential toolkit. Following credit shocks, countercyclical bank capital regulation is more effective than monetary policy in promoting financial, price and overall macroeconomic stability. For supply shocks, macroprudential regulation combined with a strong response to inflation in the central bank policy rule yield the lowest welfare losses. The findings emphasize the importance of the Basel III regulatory accords and cast doubt on the desirability of conventional Taylor rules during periods of financial distress.