Financial intermediation and the real economy: implications for monetary and macroprudential policies Stefano Neri Banca d’Italia SUERF/Deutsche Bundesbank/IMFS Conference The ESRB at 1 Berlin, 8-9 November 2011sual disclaimer applies
Outline1. The financial crisis and the debate on modelling2. Towards a new framework?3. Monetary and macroprudential policies in a model with financial intermediation
Pre-crisis consensus on macro modelling• New Keynesian framework Representative agent cash-less economy nominal rigidities → role for monetary policy no financial frictions and no intermediaries• “The paradigm that has emerged […] is one that is clearly applicable to normal times […] in developed, stable economies”, J. Galí (interview for EABCN, 2009)• Estimated models (e.g. Smets and Wouters, 2007) used for policy analysis (e.g. RAMSES at Riksbank )
The financial crisis• The crisis showed how important are the links between financial markets and the real economy many of the assumptions that characterized the new Keynesian framework were wrong financial markets are far from being efficient financial markets matter in originating and propagating shocks
Intense debate on the lessons of the crisis for economics and economic modelling• Buiter, Goodhart, Cecchetti, Spaventa and De Grauwe to mention some of critics of DSGE models• Main missing elements: financial intermediation insolvency and default liquidity regulation of intermediaries and markets booms and busts in asset markets
The crisis as an opportunity• Crisis as opportunity to modify current framework• Since Kiyotaki and Moore (1997) and Bernanke et al. (1999), few papers have considered financial intermediation in general equilibrium• Intensive research ongoing since 2009 Angeloni and Faia, Curdia and Woodford, Gertler and Kiyotaki, Bianchi and Mendoza, Jeanne and Korinek,…• They all fall short of modelling systemic risk
Towards a new framework?• Setting up a new framework that takes into account the critiques that have been raised will require time• Policy-makers are confronted with questions that require timely answers• Researchers in both academia and central banks to cooperate and develop new models• In the meantime, one possibility is to modify current models and use them for policy analysis
Monetary and macroprudential policies in a model with financial intermediationI use the model developed in Gerali et al. (2010) andmodified in Angelini et al. (2011) to answer questionsrelated to monetary and macroprudential policies 1) What was the impact of the financial crisis on economic activity in the euro area? 2) Should monetary and macroprudential policies co-operate? (BI Discussion paper, no. 801, 2011) 3) Should macroprudential policy lean against financial cycles?
The model• Based on Gerali, Neri, Sessa and Signoretti (2010) “Credit and Banking in a DSGE model of the euro area”• Medium-scale model with: real and nominal rigidities (Smets and Wouters, 2007) financial frictions à la Kiyotaki and Moore (1997) monopolistic competition in banking sector slow adjustment of bank rates to policy rate role for bank capital time-varying risk weights in bank capital regulation policy rule for bank capital requirement
The model (cont’d)• Project started in September 2007• Model has been estimated using Bayesian methods and data for the euro area over the period 1998-2009• The model has also been used to study: impact of a credit crunch on euro-area economy impact of higher capital requirements (Basel 3)• Model has some of the limitations that I have discussed
Modelling monetary and macroprudential policies• Monetary policy: interest rate rule à la Taylor Rt = (1 − ρ R ) R + (1 − ρ R ) [ χ π ( π t − π ) + χ y ( yt − yt −1 ) ] + ρ R Rt −1• Macroprudential policy: bank capital requirements rule ν t = (1 − ρν )ν + (1 − ρν ) χν X t + ρνν t −1 Xt can be any macroeconomic variable relevant for macroprudential authority
What was the impact of the financial crisis on economic activity in the euro area?• The recession in 2009 was almost entirely caused by adverse shocks to banking sector• The sharp reduction of policy rates attenuated the strong and negative effect of the crisis on the euro-area economy
Should monetary and macroprudential policies co-operate? C a pita l re q uire m e nts P o licy rate• In “normal” times 9 .1 0 .0 2 0 .0 0 macroprudential 9 .0 -0 .02 8 .9 policy yields small 8 .8 -0 .04 -0 .06 benefits 8 .7 0 10 20 30 40 -0 .08 0 10 20 30 40• If two authorities do 9 .0 0 C a p ital/a sse ts ra tio 0 .3 L o a n rate not cooperate, policy 8 .7 5 0 .2 tools are extremely 8 .5 0 0 .1 volatile 8 .2 5 0 .0• Benefits are sizeable 8 .0 0 -0 .1 0 10 20 30 40 0 10 20 30 40 when economy is hit L o a n s-to -o u tp u t ra tio O u tp u t 0 .2 0 .0 by financial shocks 0 .0 -0 .1 -0 .2 and when two -0 .4 -0 .2 authorities cooperate -0 .6 0 10 20 30 40 -0 .3 0 10 20 30 40 quarters after shock quarters after shock Cooperative Non cooperative Only monetary policy
Should macroprudential policy lean against financial cycles?• Agents expect a Capital requirements Policy rate (dev. from steady state) 9.5 0 0 .2 reduction in aggregate 9.4 0 0 .0 risk in one year time 9.3 0• For a given target for 9.2 0 -0.2 9.1 0 leverage, this provides 9.0 0 -0.4 an incentive for banks 8.9 0 0 5 10 15 20 -0.6 0 5 10 15 20 to increase lending• Shock does not 0.2 5 Output (% dev. from steady state) 2 .0 Loans-to-output ratio (dev. from steady state) Active macroprudential policy materialize 0.2 0 1 .5 No macroprudential policy• Tighter capital 0.1 5 requirements can be 0.1 0 1 .0 effective in containing 0.0 5 0 .5 expansion of lending 0.0 0 0 .0 0 5 10 15 20 0 5 10 15 20 q uarte rs afte r s ho c k q uarte rs afte r s ho c k
Implications for monetary and macroprudential policies Aggressive monetary policy can help mitigating negative impact of shocks to banking sector Monetary and macroprudential policies should closely co-operate Benefits of macroprudential policy can be sizeable when economy is hit by financial shocks Risk of coordination failure Macroprudential policy can be effective in leaning against financial cycles
Conclusions• DSGE models have undergone severe criticism• No doubt that models must be improved, but working alternative missing• Intensive research ongoing• Modeling systemic risk is key• Meanwhile, we can adapt current models with a role for financial intermediation to address questions related to monetary and macroprudential policies
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