J. (John) Fell

The global financial crisis demonstrated that monetary policy alone cannot ensure both price and financial stability. According to the Tinbergen (1952) rule, because the number of policy instruments available before the crisis was insufficient relative to the number of policy objectives, there was a gap in the policymakers’ toolkit for safeguarding financial stability. That gap is now being closed with the creation of new macroprudential policy instruments which are designed to avert systemic risk – that is, the risk of a collapse of the entire financial system. Macroprudential authorities now have a wide variety of policy instruments – including lender- and borrower-based measures – at their disposal. While these instruments can be deployed to moderate the financial cycle or enhance financial system resilience, their availability raises new questions for public policy:

• In the presence of a macroprudential policy framework, is there a role for monetary policy in preventing financial crises?

• What is the most effective assignment of macroprudential policy instruments for moderating the financial cycle and ensuring financial system resilience?

• Are there feedbacks between macroprudential policy instruments which need to be taken into account?

Each of these questions will be addressed in turn in each of the three projects comprising this PhD proposal. The first question is addressed using a simplified New-Keynesian model. It is shown that both monetary and macroprudential policy instruments have the capacity to influence either price or financial stability objectives; however, the model also shows that regardless of whether the objective is to enhance financial system resilience or to moderate the financial cycle, macroprudential policies always dominate monetary policy in their effectiveness. Likewise, monetary policy is more effective than macroprudential policy in achieving the goal of price stability. According to the Mundell (1962) principle of effective market classification, this implies that macroprudential policy instruments should be paired with financial stability objectives and monetary policy instruments should be paired with the price stability objective. Otherwise, inappropriate assignment could prove destabilising for the financial system and the real economy.

The second question can also be answered using the Mundell (1962) framework: determining the relative effectiveness of capital-based and borrower-based instruments in achieving resilience-enhancing or cycle-moderating objectives can guide appropriate assignment. While theory would suggest that both sets of instruments have the capacity to influence either of these macroprudential policy objectives, a comparison of their transmission mechanisms suggests that capital-based measures should have a comparative advantage in enhancing resilience while borrower-based instruments are likely to have an edge in moderating the cycle. The nascent empirical literature supports these hypotheses. One policy implication of this is that the need for activation of capital-based measures may be lowered when borrower-based measures are in place. Likewise, failure to moderate the financial cycle would require greater resilience-enhancing measures.

Turning to the third question, the Minsky (1992) financial instability hypothesis (FIH) predicts that economic stability, if sustained for a sufficiently long period of time, can itself breed financial instability. This endogenous view of the build-up of financial imbalances, may provide an explanation for the controversial, but seemingly robust, empirical finding of Jordà et al (2017) that “if anything, higher capital is associated with higher risk of financial crisis”. If the FIH holds, this may mean that inappropriately timed activation of capital-based macroprudential instruments could amplify rather than modulate financial cycles through a risk compensation mechanism (Peltzman (1975)), whereby the lending behaviour of banks adjusts in response to perceptions of lowered risk when actual risk is rising (Danielsson et al. (2016)). In the presence of such effects, the rationale for using borrower-based measures to moderate financial cycles is further strengthened (Vercelli (2009)).