Monetary and Macroprudential Policy Rules in a Model with House Price Booms

37 Pages·2009·0.91 MB·English

WP/09/251

Monetary and Macroprudential Policy
Rules in a Model with House Price Booms

Prakash Kannan, Pau Rabanal,
and Alasdair Scott
© 2009 International Monetary Fund WP/09/251

IMF Working Paper

Research Department

Monetary and Macroprudential Policy Rules in a Model with House Price Booms

Prepared by Prakash Kannan, Pau Rabanal, and Alasdair Scott1

Authorized for distribution by Jörg Decressin

November 2009

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

We argue that a stronger emphasis on macrofinancial risk could provide stabilization
benefits. Simulations results suggest that strong monetary reactions to accelerator
mechanisms that push up credit growth and asset prices could help macroeconomic stability.
In addition, using a macroprudential instrument designed specifically to dampen credit
market cycles would also be useful. But invariant and rigid policy responses raise the risk of
policy errors that could lower, not raise, macroeconomic stability. Hence, discretion would
be required.

JEL Classification Numbers: E52, E61

Keywords: house prices, monetary policy, macroprudential

Author’s E-Mail Address: [email protected], [email protected], [email protected],

1 The authors would like to thank Olivier Blanchard, Charles Collyns, Jörg Decressin, Antonio Fatás, Jordi Galí,
David Romer, and seminar participants at the Bank of Canada, Bank of England, Board of Governors of the
Federal Reserve, IMF, and Her Majesty’s Treasury for thoughtful discussions and comments. The remaining errors
are our own.
2
Contents Page

I. Introduction ..................................................................................................................... 4

II. A Model for Analyzing House Price Booms .................................................................. 5
A. Households ............................................................................................................. 6
A.1 Savers ............................................................................................................ 6
A.2 Borrowers ...................................................................................................... 8
B. Financial Intermediaries ....................................................................................... 10
C. Producers.............................................................................................................. 10
C.1 Final goods producers ................................................................................. 11
C.2 Intermediate goods producers ..................................................................... 11
D. Closing the Model: Market Clearing Conditions ................................................. 12

III. Policy Regimes ............................................................................................................. 13

IV. Calibration..................................................................................................................... 14

V. Simulation Results ........................................................................................................ 15
A. The Performance of Policy Rules in Reaction to Financial Shocks .................... 15
B. The Performance of Policy Rules in Reaction to Productivity Shocks ............... 17
C. Policy Rules with Multiple Shocks ...................................................................... 18

VI. Robustness of the Results ............................................................................................. 19

VII. Conclusions ................................................................................................................... 20

References ................................................................................................................................. 22

Tables
1. Parameter Values .......................................................................................................... 24
2. Parameters of Policy Rules in Reaction to Financial Shocks ....................................... 25
3. Performance of Policy Rules in Reaction to Financial Shocks ..................................... 26
4. Parameters of Policy Rules in Reaction to Productivity Shocks .................................. 27
5. Performance of Policy Rules in Reaction to Productivity Shocks ................................ 28
6. Sensitivity of Parameters of Policy Rules Optimized to Financial Shocks
to Changes in Key Parameters ............................................................................. 29
7. Sensitivity of Parameters of Policy Rules Optimized to Productivity Shocks
to Changes in Key Parameters ............................................................................. 30
3
Figures
1. Effect of a Financial Shock ........................................................................................... 31
2. Effect of a Productivity Shock ...................................................................................... 32
3. Optimal Weight on Nominal Credit in the Macroprudential Rule ............................... 33

Appendix: Linearized Conditions ............................................................................................. 34
4
I. Introduction
Empiricalworkhasfoundanumberofvariablesthatareoftenassociatedwithfutureasset
pricebusts,suchascredit,theshareofresidentialinvestmentinGDP,andcurrentaccount
balances.2 Thosesamevariablesdoreasonablywellinexplainingthedifferencesacross
countriesinhousepricerisesleadinguptothecurrentcrisis.3 Suchevidencesuggeststhatif
centralbankerswishtomitigatedamagingassetpriceboom-bustcycles,theyshouldconsider
reactingtosuchvariablesratherthanfocusingmainlyoninflationandoutput. However,there
arestillanumberofimportantquestionstobeaddressedinassessingtheappropriatepolicy
responses:
Whatarethepotentialgainsfromreactingtosignsofemergingfinancialvulnerability?
(cid:15)
Ismonetarypolicytheappropriatetoolforreactingtosuchindicators,orshouldother
(cid:15)
policiesbeused?
Whatarethetrade-offsbetweenfocusingpolicyonstabilizingoutputandCPIinflationand
(cid:15)
attemptingtoreducetheriskofassetpricecrashes?
Thispaperaddressesthesequestionswithsimulationsconductedusingamodeleconomythat
hassomeofthekeyfeaturesrelevantforexaminingthepotentialroleofmonetarypolicyin
mitigatingtheeffectsofassetpricebooms. Itmakesthecasethatputtingmoreemphasison
macrofinancialriskcouldprovidestabilizationbenefits. Theresultsfromthesimulations
suggestthatastrongermonetaryreactiontosignsofoverheatingorofacreditorassetprice
bubblecouldhelpcounteracceleratormechanismsthatpushupcreditgrowthandassetprices.
Inaddition,usingamacroprudentialinstrumentdesignedspecificallytodampencreditmarket
cycleswouldalsobeuseful. Butexpectationsshouldberealisticaboutwhatcanbeachieved
withsuchanapproach. Inparticular,itisoftendifficulttoaccuratelyidentifythesourceofthe
shockdrivingobservedhousepricebooms. Invariantandrigidpolicyresponsesraisetherisk
ofpolicyerrorsthatcouldlower,notraise,macroeconomicstability. Hence,discretionwould
needtobeappliedtotheuseofmonetaryandmacroprudentialpoliciesinattemptingto
mitigatemacrofinancialrisks.
Howdotheseconclusionscomparewiththosefromotherstudies? Thereisavastliteratureon
monetarypolicyandassetprices. Thedebatepersistsoverwhethercentralbanksshouldreact
directlytoassetprices. Twowell-knownexamplesareBernankeandGertler(2001),who
concludethatthereisnoroleforassetpricesinmonetarypolicyrules,andCecchettietal.
2See,interalia,BorioandLowe(2004)andKannanetal. (2009).
3SeeIMF(2009).
5
(2000),whoarguethatcentralbanksshouldreacttoassetprices. Increasingly,theliterature
suggestsgainsfromincludingassetpricesinmonetarypolicyrules.4 Grayetal. (2009)finda
roleforafinancialstabilityindicatorinthemonetaryrule. Twoaspectsdifferentiatethis
paper. First,wedistinguishbetweengainsthatarisefromaddingindicatorsoffinancialstress
suchasexcessivecreditgrowthtostandardbutsecondbestmonetarypolicyrulesandthose
fromincludingthesameindicatorsinfullyoptimizedrules. Second,asfarasweknow,thisis
thefirsttimethecoordinationofmonetaryandmacroprudentialruleshasbeenformally
evaluatedusingamacroeconomicmodelofthistype.5
Thepaperisstructuredasfollows. Section2containsadescriptionofthemodelandSection3
adescriptionofthepolicyregimesevaluatedinthesimulations. Section4summarizesthe
model’scalibration. TheresultsofsimulationexperimentsarepresentedinSection5. Inthe
followingsection,sensitivityanalysisisperformed. Thefinalsectionconcludes. Anappendix
detailsthelinearizedconditionsforthemodel.
II. AModelforAnalyzingHousePriceBooms
ThemodelusedinthispaperhasanumberofmodificationstothestandardNewKeynesian
model(Galí,2009)withregardtothecharacterizationofhouseholdsandfinancialmarkets,
whichcreateaspecialroleforassetprices. Becausehousingwealthisgenerallymore
importantformosthouseholdsthanequities,andbecausehousepurchasestypicallyrequire
debtfinancing,weconcentrateontheroleofhousing.6 First,householdsmakechoicesabout
howmuchtoinvestinhousing,aswellashowmuchtoconsumeinnondurablegoods.
Housingisanassetthatprovidesservicesandisthemainvehicleforaccumulatingwealthin
thiseconomy. Second,wemakeadistinctionbetweenborrowersandlenders,creating
conditionsforleverage. Third,thelendingrateismodeledasaspreadoverthepolicyratethat
dependsonloan-to-valueratios,themarkupchargedoverfunding(policy)rates,and,insome
casesdiscussedbelow,amacroprudentialinstrument. Hence,lendingratescanchangefora
numberofreasons: forexample,ariseinhousepriceswillraisemarketvaluationsof
borrowers’collateral,loweringtheaverageloan-to-valueratio,andwillthereforeleadtoafall
inlendingratesevenifmonetarypolicyhasnoteased. Creditmarketconditionscan
change—becauseof,say,changesinperceptionsofriskorcompetitivenessinlending—which
4RecentexamplesincludeChristianoetal. (2007).
5GrussandSgherri(2009)studythewelfareimplicationsofprocyclicalloan-to-valueratiosinatwo-country
model. However, because the model does not have a nominal side, the reaction of monetary policy cannot be
addressed.
6For a model that considers the monetary policy implications of stock price fluctuations, see Christiano and
others(2007).
6
couldleadbankstoadjusttheirmarkupsandthereforealterthelendingspread. Bothofthese
mechanismshelpaccelerateariseinresidentialinvestment,nondurableconsumption,and
prices.7 Insomesimulations,policymakerscanaffectspreadsdirectly,usinga
macroprudentialtool,inadditiontoinfluencinglendingratesviapolicyrates.
Inotheraspects,themodelhasconventionalNewKeynesianfoundations. Thetheoretical
frameworkconsistsofageneralequilibriumtwo-sectormodel,durablesandnon-durables,
whereeachsectoroperatesundermonopolisticcompetitionandnominalrigidities. Pricesin
bothsectorsarestickyintheshortrun,asinCalvo(1983). Consumptionandresidential
investmentadjustslowlydue,respectively,tohabitformationandadjustmentcosts. Itis
costlyforworkerstoshiftfromworkingontheproductionofconsumptiongoodstobuilding
houses,andviceversa. Forsimplicity,thereisnocapitalusedinproductionandtheeconomy
isclosed.
A. Households
Householdsobtainutilityfromconsumingthestockofdurablesandtheflowofnondurables.
Therearetwotypesofhouseholdsinthiseconomy,borrowersandsavers. Borrowersare
assumedtobemoreimpatientthansavers,byhavingasmallerdiscountfactor. Inequilibrium,
saverswillprovidefinancingtoborrowers. Afraction(cid:21)ofhouseholdsareconsideredtobe
savers,theremainingfraction1 (cid:21)areborrowers.
(cid:0)
A.1 Savers
Eachsaverj [0;(cid:21)]maximizesthefollowingutilityfunction:
2
Lj 1+’
E 1 (cid:12)t (cid:13)log(Cj "C )+(1 (cid:13))log(Dj) t ; (1)
0(t=0 " t (cid:0) t(cid:0)1 (cid:0) t (cid:0) (cid:0)1+(cid:1) ’ #)
X
whereCj denotesconsumptionofnon-durablegoods,Dj denotesconsumptionofdurable
t t
goods,andLi;j denoteshoursworkedbyhouseholdj ineachsectori = C;D. (cid:12) isthe
t
discountfactor. Householdsformexternalhabitsinconsumption,asinSmetsandWouters
(2003)andIacovielloandNeri(2009),with"denotingtheimportanceofthehabitstock,
whichislastperiod’saggregateconsumption(C ). Finally,followingIacovielloandNeri
t 1
(cid:0)
7ThesefeaturesdrawonelementsofmodelsbyAokietal. (2004), CurdiaandWoodford(2009), Iacoviello
(2005), and Monacelli (2009). The accelerator mechanism goes back to Bernanke et al. (BGG, 1998); unlike
BGG,theacceleratorinthismodelworksthroughhousingfinanceratherthanfirms’capital.
7
(2009),weassumethatthereisimperfectsubstitutabilityoflaborsupplyacrosssectors,such
thatthelabordisutilityindexcanbewrittenas
1
Lj = (cid:11) (cid:19)L LC;j 1+(cid:19)L +(1 (cid:11)) (cid:19)L LD;j 1+(cid:19)L 1+(cid:19)L ; where(cid:19) > 0; (2)
t (cid:0) t (cid:0) t L
(cid:0)
(cid:20) (cid:21)
(cid:16) (cid:17) (cid:16) (cid:17)
and(cid:11) istheeconomicsizeofeachsector. Thisimperfectsubstitutabilityimpliesthat
reallocatinglaboracrosssectorsfollowingashockiscostly. Notethatwhen(cid:19) = 0the
L
aggregatorislinearinhoursworkedineachsector,sotherearenocostsofswitchingfrom
workinginonesectortotheother. Thiscosthelpsthemodeltoexplainpositivecomovement
ofrealvariablesinbothsectorsinresponsetoaggregateshocks.
Thebudgetconstraintofthesavers,innominalterms,isgivenby
PCCj +PDIj +Bj R Bj +WCLC;j +WDLD;j +(cid:5)j; (3)
t t t t t (cid:20) t(cid:0)1 t(cid:0)1 t t t t t
wherePC andPD arethepriceindicesofdurableandnon-durablegoods,respectively,Wi is
t t t
thenominalwageineachsectori = C;D,andBj denotessavinginstruments(suchasdebt
t
instrumentsordeposits)thatborrowersplaceinbanks,atagrossinterestrateofR . (cid:5)j
t t
denotesnominalprofitsfromintermediategoodsproducingfirmsandbanks,whichare
ultimatelyownedbysavers.
Ij denotesresidentialinvestment. Weassumethatthelawofmotionofthehousingstock
t
evolvesasfollows:
Ij
Dj = (1 (cid:14))Dj + 1 S t Ij; (4)
t (cid:0) t(cid:0)1 " (cid:0) Ij !# t
t 1
(cid:0)
where(cid:14) denotestherateofdepreciationofthehousingstockand,followingChristiano,
Eichenbaum,andEvans(2005),weintroduceanadjustmentcostfunction,S(:),whichis
(cid:22) (cid:22) (cid:22)
convex(i.e. S () > 0). InthesteadystateS = S(cid:19)= 0andS > 0:Theaimofintroducingthis
00 00
costistoallowforthepossibilitythatthemodelcangeneratehump-shapedresponsesof
residentialinvestmenttoshocks.
Thefirstorderconditionstothehouseholdmaximizationproblemaregivenbythefollowing
expressions,where(cid:21) istheLagrangemultiplierassociatedwiththebudgetconstraint,and(cid:22)
t t
istheLagrangemultiplierassociatedwithequation(4):8
U = (cid:21) PC (5)
Ct t t
8Sinceallsaversbehavethesameway,wedropthej subscriptsinwhatfollows.
8
U = (cid:22) (cid:12)(1 (cid:14))E (cid:22) (6)
Dt t (cid:0) (cid:0) t t+1
I I I I I 2
(cid:21) PD = (cid:22) 1 S t S t t +(cid:12)E (cid:22) S t+1 t+1 (7)
t t t (cid:0) I (cid:0) 0 I I t t+1 0 I I
(cid:26) (cid:18) t 1(cid:19) (cid:18) t 1(cid:19) t 1(cid:27) " (cid:18) t (cid:19)(cid:18) t (cid:19) #
(cid:0) (cid:0) (cid:0)
Absentadjustmentcoststoresidentialinvestment(i.e. S = 0),thesethreeequationscanbe
reducedtothefollowingcondition:
PD 1 (cid:13) (cid:24)D(C "C ) C "C PD
PtC = (cid:0)(cid:13) t tD(cid:0) t(cid:0)1 +(cid:12)(1(cid:0)(cid:14))Et Ct (cid:0) "tC(cid:0)1 PtC+1
t t (cid:20)(cid:18) t+1 (cid:0) t(cid:19) t+1(cid:21)
Notethatifthedurablegoodisinfactcompletelynon-durable(i.e. (cid:14) = 1),thiscondition
simplyequatesthemarginalutilitiesofconsumptiontorelativeprices. Sincethedurablegood
hasaresidualvaluethefollowingperiod,thisinducestheextra-termofholdinganadditional
unitofthedurablegood.
TheEulerequationfortheconsumptionofnon-durablegoodswithhabitsisstandard:
PC C "C
1 = (cid:12)RtEt PCt Ct (cid:0) "tC(cid:0)1 ; (8)
(cid:20) t+1 (cid:18) t+1 (cid:0) t(cid:19)(cid:21)
andthelaborsupplyconditionstobothsectorsaregivenby
(cid:13) WC
L’t(cid:0)(cid:19)L(cid:11)(cid:0)(cid:19)L LCt (cid:19)L = C "C PCt
(cid:18) t (cid:0) t(cid:0)1(cid:19) t
(cid:0) (cid:1)
and
(cid:13) WD
L’t(cid:0)(cid:19)L(1(cid:0)(cid:11))(cid:0)(cid:19)L LDt (cid:19)L = C "C PtC : (9)
(cid:18) t (cid:0) t(cid:0)1(cid:19) t
(cid:0) (cid:1)
A.2 Borrowers
Eachborrowerj [(cid:21);1]maximizesthefollowingutilityfunction:
2
1+’
LB;j
1 t
E (cid:12)B;t (cid:13)log(CB;j "CB )+(1 (cid:13))(cid:24)Dlog(DB;j) ; (10)
08 2 t (cid:0) t 1 (cid:0) t t (cid:0) (cid:16) 1+(cid:17)’ 39
(cid:0)
><Xt=0 >=
6 7
4 5
> >
: ;
9
inwhichallvariableswithaB superscriptaretheborrowers’analogtothesavers’variables
above. (cid:12)B < (cid:12) isthediscountfactoroftheborrowers;itisassumedthatborrowersaremore
impatientthansavers. Theirbudgetconstraintinnominaltermsisgivenby
PCCB;j +PDIB;j +RL BB;j BB;j +WCLC;B;j +WDLD;B;j: (11)
t t t t t 1 t 1 (cid:20) t t t t t
(cid:0) (cid:0)
BorrowerscanobtainloansfrombanksatalendingrateofRL:
t
Weassumethatthefunctionalformsforaggregatelaborsupply,LB;j,andforthelawof
t
motionofhousingstock,DB;j;arethesameasinthecaseofsavers. Hence,thefirstorder
t
conditionsfortheborrowerhouseholdsaregivenby
U = (cid:21)BPC; (12)
CB t t
t
U = (cid:22)B (cid:12)B(1 (cid:14))E (cid:22)B ; (13)
DtB t (cid:0) (cid:0) t t+1
and
IB IB IB IB IB 2
(cid:21)BPD = (cid:22)B 1 S t S t t +(cid:12)BE (cid:22)B S t+1 t+1 :
t t t (cid:0) IB (cid:0) 0 IB IB t t+1 0 IB IB
(cid:26) (cid:18) t 1(cid:19) (cid:18) t 1(cid:19) t 1(cid:27) " (cid:18) t (cid:19)(cid:18) t (cid:19) #
(cid:0) (cid:0) (cid:0)
(14)
TheEulerequationforborrowersis
(cid:21)B = (cid:12)BRLE (cid:21)B : (15)
t t t t+1
SubstitutingfortheexpressionofmarginalutilityweobtaintheconsumptionEulerequation
forborrowers:
PC CB "CB
1 = (cid:12)BRLE t t (cid:0) t 1 ; (16)
t t PC CB "C(cid:0)B
(cid:20) t+1 (cid:18) t+1 (cid:0) t (cid:19)(cid:21)
whilethecorrespondinglaborsupplyconditionstobothsectorsaregivenby
LBt ’(cid:0)(cid:19)L(cid:11)(cid:0)(cid:19)L LBt ;C (cid:19)L = CB (cid:13)"CB WPCtC
(cid:0) (cid:1) (cid:16) (cid:17) (cid:18) t (cid:0) t(cid:0)1(cid:19) t
and
LBt ’(cid:0)(cid:19)L(1(cid:0)(cid:11))(cid:0)(cid:19)L LBt ;D (cid:19)L = CB (cid:13)"CB WPtCD: (17)
(cid:0) (cid:1) (cid:16) (cid:17) (cid:18) t (cid:0) t(cid:0)1(cid:19) t