Macroprudential Policies in a Low Interest-Rate Environment

In the aftermath of the global financial crisis, a new set of challenges has emerged for macroeconomic policy makers. One of the major changes in the post-crisis environment is a significant and permanent decline in interest rates. In many economies, the short-term nominal interest rate has been close to zero. Monetary policymakers have encountered difficulties in stimulating the economy because the interest rate cannot be lowered any further. Moreover, when interest rates are persistently low, agents tend to engage in speculative investment in assets, such as real estate. Therefore, low interest rates may also contribute to asset price bubbles and excessive leverage, which pose risks to financial stability. One of the policies that has become important after the crisis is the so-called macroprudential policy, aimed at ensuring a more stable financial system. In this paper, we focus on the use of macroprudential policies in an economic environment in which interest rates are low. We argue that, in a low interest-rate environment, the case for using macroprudential policies becomes even stronger. On the one hand, greater financial volatility due to low interest rates calls for macroprudential policies to contain excessive bank lending. On the other hand, macroprudential policy may also complement monetary policy when the interest rate is close to zero and cannot be used to stabilise the economy anymore. We build an economic model for policy evaluation that can take into account that nominal interest rates are subject to a zero lower bound and cannot become negative. We calibrate the model to characteristics of the US economy where the Federal funds rate has been close to zero for 7 years. Within this setting, we find that when the interest rate is persistently low, activity in the financial markets and the wider economy, becomes more volatile. Therefore, we propose macroprudential policy as a candidate to stabilise the economy in this context. On the one hand, we find that in a low interest-rate environment, tighter macroprudential policies can stabilise financial markets. We also find, on the other hand, that macroprudential policies could help monetary policy stimulate the economy when interest rates are close to zero.


Introduction
In the post GFC world, there are new challenges to the conduct of macro-…nancial stabilization policies One of the major changes in this new environment is a signi…cant decline in the neutral interest rate

Macroprudential Policy in a Low Interest-Rate Environment
In a low interest-rate environment, the case for using macroprudential policies becomes even stronger Monetary policy in the model is described by a standard Taylor rule, which is subject to an occasionally binding ZLB Macroprudential policy is characterized by a rule on the loan-to-value ratio (LTV) that responds to credit and output

Borrowers
Borrowers solve the following optimization problem: where b 2 (0; 1) is the discount factor for the borrower ( b < s ), subject to the following budget and collateral constraints: The intermediate goods market is monopolistically competitive: A t represents technology and it follows the following autoregressive process: Solving the …rm's problem we can obtain a standard forward-looking New Keynesian Phillips curve:

Monetary Policy
We consider a standard Taylor rule which responds to in ‡ation and output, with interest-rate smoothing: The Model Occbin ZLB Low rates Macropru Conclusion

Macroprudential Policy
A macroprudential rule for the LTV: extended to include an output term.  Model dynamics with occbin (2) With occasionally binding constraints for the interest rate, the policy rate reaches the zero lower bound and stays there for a couple of periods before converging to the Taylor rule interest rate The non-constrained interest rate, however, becomes negative.
Both output and in ‡ation respond in a much stronger manner in the world in which the interest rate is constrained.
The negative impact of the productivity shock is ampli…ed by the collateral channel of borrowers, even without a ZLB. When the interest rate is restricted by the ZLB, the latter provides an additional ampli…cation of the shock: The combination of de ‡ation and the binding ZLB of the nominal interest rate pushes up the real cost of borrowing, which further depresses house prices and credit, triggering the collateral e¤ect on the real economy.

Introduction
The Model Occbin ZLB Low rates Macropru Conclusion

A low interest-rate environment
The decline in the long-term interest rate, especially in the post-crisis period, may have implications both for …nancial stability and the implementation of monetary policy.
We explore the consequences of a low steady-state interest rate, when an occasionally binding ZLB is explicitly considered We simulate our model with the same productivity shock process under two levels of steady-state interest rates (4% and 2%) Given the same size of shocks, we show that, in a low interest-rate environment, the interest rate is more likely to hit the ZLB and the economy is more volatile than the economy with a high interest rate.

Introduction
The  Simulations (2) In "normal times" the economy never hits the ZLB, while in the "low interest-rate" setting, the constraint binds several times and for extensive periods.
In "normal times" the economy is less volatile than in a "low interest-rate" environment.

Introduction
The How can macroprudential policy help?
A natural candidate that could help monetary policy in this situation is macroprudential policy.
In a low interest-rate world, the case for using macroprudential policies is even stronger: It can be used to deal with …nancial instability, which is an important problem in this case It can act as a complement to monetary policy when it hits the ZLB to stabilize the real economy The Simulations (1) We …rst compare the impulse responses of the model with and without an active LTV rule, taking the monetary policy rule as given As a starting point, we study a simple LTV rule that responds only to credit: where we tentatively set the reaction parameter b to 0:2.

Introduction
The

Introduction
The Model Occbin ZLB Low rates Macropru Conclusion

Simulations (3)
Without an active LTV policy, the interest rate immediately drops to the ZLB and stays there for a few periods The economy su¤ers a deep recession, where both output and in ‡ation fall The e¤ect of a negative productivity shock is ampli…ed by the collateral channel and the rising real interest rate due to the binding ZLB When a countercyclical LTV rule can be used to help the economy, it relaxes the LTV by about 10 percentage points.
The provision of credit is supported by the LTV loosening In ‡ation increases instead of falling, which lifts the interest rate out of the ZLB more quickly The real interest rate falls, providing the real economy with the kind of support that would have been achieved by monetary policy Optimal simple rules for the LTV We assess the optimal combination of parameters in the LTV rule, which minimizes a loss function of the macroprudential authority, taking monetary policy as given We assume that the macroprudential authority cares about the variability of credit, as a proxy for …nancial stability, and the variability of the instrument: Searching over a grid of parameters, the solution of this problem is represented by the following expression: The rule as a complement for monetary policy As a …rst approach, we consider a rule in which the macroprudential regulator only responds to credit deviations from the steady state, that is, we impose y = 0 Then, we extend the rule to allow the macroprudential instrument to also respond to output.

LTV rule with credit
When we introduce an active LTV rule responding to credit only, …nancial stability is improved dramatically without compromising macroeconomic stability In normal times, the macroprudential policy delivers a much lower variability of credit and it also helps with macroeconomic stability In the 2% interest-rate world, however, the optimized LTV rule has to respond to credit more aggressively, and it dampens mostly the volatility of credit,

Introduction
The Model Occbin ZLB Low rates Macropru Conclusion

Extended LTV rule
In normal times, since monetary policy already does its job properly, there is no need for the LTV rule to respond to output directly The so-called "Tinbergen principle" applies When the economy is closer to the ZLB, however, the optimized rule responds more strongly to output than to credit Monetary policy is often constrained by the binding ZLB In this case, macroprudential policy has to lend a helping hand to monetary policy, to assist macroeconomic stabilization As a result, the whole economy improves in terms of the volatilities in both the macroeconomic and the …nancial sector

Introduction
The Conclusion (1) We build a DSGE model in which interest rates are permanently low and monetary policy is constrained by the ZLB We study the implementation of macroprudential policies, represented by an LTV rule In particular we answer the following research questions: Are macroprudential policies more relevant in a low interest-rate environment? Can macroprudential policies complement monetary policy when the latter binds at the ZLB occasionally?

Introduction
The Conclusion (2) We …nd that when interest rates are persistently low, the ZLB occurs frequently, leading to greater macroeconomic volatility and …nancial instability In this context, the economy calls for the use of active macroprudential policies to promote …nancial stability and to act as a complement to the less e¤ective monetary policy.
We …nd that in a low interest-rate environment, macroprudential policies need to be more aggressive in responding to credit.
Furthermore, when the LTV is allowed to respond to output, it will respond to output more strongly than to credit Macroprudential policies can act as a complement to monetary policy.