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When capital adequacy and interest rate policy are substitutes (and when they are not)

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  • Stephen G Cecchetti
  • Marion Kohler

Abstract

Prudential instruments are commonly seen as the tools that can be used to deliver the macroprudential policy goals of reducing the frequency and severity of financial crises. And interest rates are traditionally viewed as the means to deliver the macroeconomic stabilisation goals of low, stable inflation and sustainable, stable growth. But, at the macroeconomic level, these two sets of policy tools have quite a bit in common. We use a simple macroeconomic model to study the extent to which capital adequacy requirements and interest rates might be substitutes in meeting the objective of stabilising the economy. We find that in our model both are substitutes for achieving conventional monetary policy objectives. In addition, we show that, in principle, they can both be used to meet financial stability objectives. This implies a need to coordinate the use of macroprudential and traditional monetary policy tools, a need that has clear implications for the construction of the policy framework designed to deliver the joint objectives of macroeconomic and financial stability.

Suggested Citation

  • Stephen G Cecchetti & Marion Kohler, 2012. "When capital adequacy and interest rate policy are substitutes (and when they are not)," BIS Working Papers 379, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:379
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    References listed on IDEAS

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    1. Claudio Borio & Mathias Drehmann, 2011. "Toward an Operational Framework for Financial Stability: “Fuzzy” Measurement and Its Consequences," Central Banking, Analysis, and Economic Policies Book Series, in: Rodrigo Alfaro (ed.),Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 4, pages 063-123, Central Bank of Chile.
    2. William Poole, 1969. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Special Studies Papers 2, Board of Governors of the Federal Reserve System (U.S.).
    3. Ben S. Bernanke & Mark Gertler, 1995. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 27-48, Fall.
    4. Gabriele Galati & Richhild Moessner, 2013. "Macroprudential Policy – A Literature Review," Journal of Economic Surveys, Wiley Blackwell, vol. 27(5), pages 846-878, December.
    5. Charles R. Bean & Matthias Paustian & Adrian Penalver & Tim Taylor, 2010. "Monetary policy after the fall," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 267-328.
    6. Stephen G. Cecchetti & Lianfa Li, 2008. "Do Capital Adequacy Requirements Matter For Monetary Policy?," Economic Inquiry, Western Economic Association International, vol. 46(4), pages 643-659, October.
    7. Stan du Plessis & Gideon du Rand, 2011. "On the (non-)equivalence of capital adequacy and monetary policy: A response to Cechetti and Kohler," Working Papers 04/2011, Stellenbosch University, Department of Economics.
    8. Michael Woodford, 2012. "Inflation Targeting and Financial Stability," NBER Working Papers 17967, National Bureau of Economic Research, Inc.
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    10. William R. White, 2006. "Is price stability enough?," BIS Working Papers 205, Bank for International Settlements.
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    More about this item

    Keywords

    Monetary policy; capital adequacy policy; financial stability policy;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G2 - Financial Economics - - Financial Institutions and Services

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