The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability, raising questions about how to combine monetary and prudential policies. This paper characterizes the jointly optimal monetary and prudential policies, setting the interest rate and bank-capital requirements. The source of financial fragility is the socially excessive risk taking by banks due to limited liability and deposit insurance. We provide conditions under which locally (Ramsey) optimal policy dedicates the prudential instrument to preventing inefficient risk taking by banks, and the monetary instrument to dealing with the business cycle, with the two instruments covarying either negatively, or positively and countercyclically.
Collard, Fabrice, Harris Dellas, Behzad Diba, and Olivier Loisel.
"Optimal Monetary and Prudential Policies."
American Economic Journal: Macroeconomics,
Business Fluctuations; Cycles
Interest Rates: Determination, Term Structure, and Effects
Financial Markets and the Macroeconomy
Banks; Depository Institutions; Micro Finance Institutions; Mortgages
Financial Institutions and Services: Government Policy and Regulation