Macroprudential Policies and Financial Staility

The paper attempts to assess to what extent the central bank or the govern- ment should respond to developments that can cause financial instability, such as housing or asset bubbles, overextended budgetary policies, or excessive public and household debt. To analyze this question we set up a simple reduced-form model in which monetary and fiscal policy interact, and imbalances (bubbles) can occur in the medium-run. Considering several scenarios with both benevolent and idio- syncratic policymakers, the analysis shows that the answer depends on a number of characteristics of the economy, as well as on the monetary and fiscal policy pref- erences with respect to inflation and output stabilization. We show that socially optimal financial instability prevention should be carried out by: (i) both mone- tary and fiscal policy ('sharing region') under some circumstances, and (ii) fiscal policy only ('specialization region') under others. There is however a moral haz- ard problem: both policymakers have an incentive to be insusufficiently pro-active in safeguarding financial stability, and shift the responsibility to the other policy. Specifically, under a range of circumstances we obtain a situation in which nei- ther policy mitigates instability threats ('indifference region'). These results can be related to the build-up of the current global financial crisis, and have strong implications for the optimal design of the delegation process.