In this paper, we study the optimal mix of monetary and macroprudential policies in an estimated two-country model of the euro area. The model includes real, nominal and financial frictions, and hence both monetary and macroprudential policy can play a role. We find that the introduction of a macroprudential rule would help in reducing macroeconomic volatility, improve welfare, and partially substitute for the lack of national monetary policies. Macroprudential policy would always increase the welfare of savers, but their effects on borrowers depend on the shock that hits the economy. In particular, macroprudential policy may entail welfare costs for borrowers under technology shocks, by increasing the countercyclical behavior of lending spreads.

The financial crisis highlighted the importance of systemic risks and of policies that can be employed to prevent and mitigate them. Several recent initiatives aim at establishing institutional frameworks for macro-prudential policy. As this process advances further, substantial uncertainties remain regarding the transmission channels of macro-prudential instruments as well as the interactions with other policy functions, and monetary policy in particular. This paper provides an overview and some illustrative model simulations using an estimated DSGE model for the euro area of the macroeconomic interdependence between macro-prudential instruments and monetary policy.

We analyse the effects of macroprudential and monetary policies and their interactions using an estimated dynamic stochastic general equilibrium (DSGE) model tailored to Sweden. Households face a ceiling on their loan-to-value ratio and must amortize their mortgages. The government grants mortgage interest payment deductions. Lending rates are affected by mortgage risk weights. We find that demand-side macroprudential measures are more effective in curbing household debt ratios than monetary policy, and they are less costly in terms of foregone consumption. A tighter macroprudential stance is also found to be welfare improving, by promoting lower consumption volatility in response to shocks, especially when using a combination of macroprudential instruments.

The crisis has highlighted the importance of setting up macro-prudential oversight frameworks, having effective macro-prudential instruments in place to be called upon to mitigate growing financial imbalances as needed. We develop a new approach using the euro area Bank Lending Survey to assess the effectiveness of macro-prudential policies in containing credit growth and house price appreciation in mortgage markets. We find instruments targeting the cost of bank capital most effective in slowing down mortgage credit growth, and that the impact is transmitted mainly through price margins, the same banking channel as monetary policy. Limits on loan-to-value ratios are also effective, especially when monetary policy is excessively loose.

Recent financial crisis has shown that the prior belief that the active monetary policy in pursuing price stability may not be sufficient enough to maintain financial stability as well as macroeconomic stability in an economy.

We study alternative monetary policy strategies in the presence of the lower bound on nominal interest rates and a low equilibrium real rate using an estimated DSGE model for the euro area. We demonstrate that simple feedback rules that implement inflation targeting result in a binding lower bound one-fourth of the time as well as inflation and output exhibiting large downward biases and heightened volatility. Rule-based asset purchases that are activated once the policy rate reaches the lower bound are not able to fully offset the destabilizing effects of the lower bound if we assume plausible limits on the size of purchases. Makeup strategies, especially average inflation targeting with a long averaging window, perform better than inflation targeting. However, differences in performance across strategies become small if the response coefficients of the feedback rules are optimized. In addition, we find that the benefits of makeup strategies tend to vanish if agents exhibit a degree of inattention to central bank policies as estimated in the data.