Monetary Macroprudential Policy Mix under Financial Frictions Mechanism with DSGE Model

The experience from the recent global financial crisis on 2008/2009 showed that most macroeconomic instabilities came from the financial/banking sector. The condition of the financial system may affect monetary stability, through excessive pro-cyclicality in the financial system. Agung et al (2010) stated that pro-cyclicality level of financial sector in Indonesia is quite high. The evidence can be seen from the real credit which grew faster than GDP in the period of expansion, and vice versa. On the other hand, monetary policy may also affect the company's risk-taking behavior in financial markets, by affecting the company’s balance sheet as well as bank (credit portfolio, asset, etc.), which in turn will affect the stability of the financial system. Bernanke and Gertler (2001) stated that an aggressive monetary policy will not provide a significant advantage to regulate the movement of asset prices, due to the large volatility of financial variables. Hence, it is necessary to establish a combination of policy instruments to achieve price stability and financial stability. To formulate policies for price stability and financial market, we built a DSGE model that has the ability to simulate the effects of monetary and macroprudential policies in Indonesia. We incorporated a credit channel and financial intermediation mechanism in the model to capture pro-cyclicality in the financial sector, which will influence the dynamics of the business cycle, as suggested by Roger and Vleck (2011). The model is built on the basis of Gerali et al (2010) who have entered the banking sector with collateral constraint in the New Keynesian DSGE models a la Christiano et al (2005), and also adding a model of the financial accelerator approach a la Bernanke et al (1999) which has been modified by Zhang (2009). We used two approaches to model financial frictions in the financial sector: (i) collateral constraint, imposed on bank lending to households; and (ii) financial accelerator, imposed on lending to entrepreneurs. Collateral constraints mechanism in the household borrowing allows simulation of macroprudential policies such as the LTV ratio, which has been implemented in Indonesia for the last few years. On the other hand, the financial accelerator mechanism imposed on the entrepreneurs affected their decision to borrow from the bank to purchase their capital needs. The model that we developed is a small open economy DSGE model that has economic agents such as households (patient and impatient) conducting consumption, labor supply, savings to and borrowings from banks and paying taxes to the government. In addition there are entrepreneurs, intermediate good producers, capital good producers, housing producers and final good producers associated with the production of goods, the production of capital, as well as the final goods aggregator. This model also has a wide range of retailers, namely domestic retailers, importer retailers and exporter retailers that served to differentiate homogenous goods at no cost and sell them at a certain profit, with the opportunity to change the selling price following the usual mechanism from Calvo (1983). The condition of the financial system may affect monetary stability, through excessive pro-cyclicality in the financial system. The evidence can be seen from the real credit which grew faster than GDP in the period of expansion, and vice versa. On the other hand, monetary policy may also affect the company's risk-taking behavior in financial markets, by affecting the company’s balance sheet as well as bank (credit portfolio, asset, etc.), which in turn will affect the stability of the financial system. Hence, it is necessary to establish a combination of policy instruments to achieve price stability and financial stability. This model should describe the economic condition under monetary and macro prudential policy mix response if there are any shock happened. As the result, the model has detail treatment of banking sector according to Indonesia context. The transmission of macro-prudential policy shock is studied by analyzing the impulse responses to shock some variable, especially LTV. We find that macro-prudential policy plays an important role to dampen excessive economic and financial cycles in Indonesia. We also find that the results are better when macro-prudential instruments are exercised together with appropriate monetary policy responses. Therefore coordination between monetary policy and macro-prudential policy is critical In order to obtain optimum results in achieving macroeconomic stability and financial system stability.