Monetary and Macroprudential Policy Coordination with Biased Preferences

Abstract

This paper studies the extent to which biased policy preferences, motivated by narrow institutional mandates, affect the gains from coordination between monetary policy(which may respond to financial imbalances) and macroprudential regulation (in the form of capital requirements) in responding to financial stability considerations, and whether these mandates can be set optimally. Numerical experiments show that, depending on the degree of bias in policy preferences, coordination may not entail burden sharing (in the sense of one policymaker reacting more, and the other less, aggressively to financial stability concerns) and may not be Pareto improving relative to the Nash equilibrium–even though it can generate significant gains for the economy as a whole. The optimal institutional mandate, based on maximizing household welfare under coordination, internalizes the impact of the cost of each policymaker’s own instrument use on policy decisions. As a result, there may be an inverse relationship between the degree of bias in preferences and the instrument cost.