Financial Regulation, Credit and Liquidity Policy and the Business Cycle

The global financial crisis in 2007 prompted policy makers to introduce a combination of bank regulation and macroprudential policies, including non-conventional monetary policies, such as interest on reserves and changes in required reserves. This paper examines how the combination of such policies can help stabilize the effects of real and financial shocks in economies where financial frictions are important. Although there is an extensive literature on financial regulation and macro-prudiential policy, and more recently some literature on the effects of interest on reserves, these policies are usually examined independently. The results point to the importance of coordination between financial regulation and monetary policy in minimizing welfare losses following such shocks. Interest on reserves is shown to be more effective in reducing welfare losses than changes in required reserves and to play a signicant role in making stabilization policy more effective. The results also suggest an easing of bank capital requirements during recessions, when output and loans are falling and the risk of default is high.