Tuesday, April 24, 2012

Central Bank Independence and Macro-prudential Regulation. By Kenichi Ueda & Fabian Valencia

Central Bank Independence and Macro-prudential Regulation. By Kenichi Ueda & Fabian Valencia
IMF Working Paper No. 12/101
Apr 2012

Summary: We consider the optimality of various institutional arrangements for agencies that conduct macro-prudential regulation and monetary policy. When a central bank is in charge of price and financial stability, a new time inconsistency problem may arise. Ex-ante, the central bank chooses the socially optimal level of inflation. Ex-post, however, the central bank chooses inflation above the social optimum to reduce the real value of private debt. This inefficient outcome arises when macro-prudential policies cannot be adjusted as frequently as monetary. Importantly, this result arises even when the central bank is politically independent. We then consider the role of political pressures in the spirit of Barro and Gordon (1983). We show that if either the macro-prudential regulator or the central bank (or both) are not politically independent, separation of price and financial stability objectives does not deliver the social optimum.



A growing literature based on models where pecuniary externalities reinforce shocks in the aggregate advocates the use of macro-prudential regulation (e.g. Bianchi (2010), Bianchi and Mendoza (2010), Jeanne and Korinek (2010), and Jeanne and Korinek (2011)). Most research in this area has focused on understanding the distortions that lead to financial amplification and to assess their quantitative importance. The natural next question is how to implement macro-prudential regulation.

Implementing macro-prudential policy requires, among other things, figuring out the optimal institutional design. In this context, there is an intense policy debate about the desirability of assigning the central bank formally with the responsibility of financial stability. This debate has spurred interest in studying the interactions between monetary and macro-prudential policies with the objective of understanding the conflicts and synergies that may arise from different institutional arrangements.

This paper contributes to this debate by exploring the circumstances under which it may be suboptimal to have the central bank in charge of macro-prudential regulation. We differ from a rapidly expanding literature on macro-prudential and monetary interactions, including De Paoli and Paustian (2011) and Quint and Rabanal (2011), mainly in that our focus is on the potential time-inconsistency problems that can arise, which are not addressed in existing work. Our departure point is the work pioneered by Kydland and Prescott (1977) and Barro and Gordon (1983) who studied how time-inconsistency problems and political pressures distort the monetary authority’s incentives under various institutional arrangements. In our model, there are two stages, in the first stage, the policymaker (possibly a single or several institutions) makes simultaneous monetary policy and macro-prudential regulation decisions. In the second stage, monetary policy decisions can be revised or “fine-tuned” after the realization of a credit shock.  This setup captures the fact that macro-prudential regulation is intended to be used preemptively, once a credit shock (boom or bust) have taken place, it can do little to change the stock of debt. Monetary policy, on the other hand, can be used ex-ante and ex-post.

The key finding of the paper is that a dual-mandate central bank is not socially optimal. In this setting, a time inconsistency problem arises. While it is ex-ante optimal for the dual-mandate central bank to deliver the socially optimal level of inflation, it is not so ex-post. This central bank has the ex-post incentive to reduce the real burden of private debt through inflation, similar to the incentives to monetize public sector debt studied in Calvo (1978) and Lucas and Stokey (1983).  This outcome arises because ex-post the dual-mandate central bank has only one tool, monetary policy, to achieve financial and price stability.

We then examine the role of political factors with a simple variation of our model in the spirit of Barro and Gordon (1983). We find that the above result prevails if policy is conducted by politically independent institutions. However, when institutions are not politically independent (the central bank, the macro-prudential regulator, or both) neither separate institutions nor combination of objectives in a single institution delivers the social optimum. As in Barro and Gordon (1983), the non-independent institution will use its policy tool at hand to try to generate economic expansions. The non-independent central bank will use monetary policy for this purpose and the non-independent macro-prudential regulator will use regulation. Which arrangement generates lower welfare losses in the case of non-independence depends on parameter values. A calibration of the model using parameter values from the literature suggest, however, that a regime with a non-independent dual-mandate central bank almost always delivers a worse outcome than a regime with a non-independent but separate macro-prudential regulator.

Finally, if the only distortion of concern is political interference (i.e. ignoring the time-inconsistency problem highlighted earlier) all that is needed to achieve the social optimum is political independence, with separation or combination of objectives yielding the same outcome.  From a policy perspective, our analysis suggests that a conflict between price and financial stability objectives may arise if pursued by a single institution. Our results also extend the earlier findings by Barro and Gordon (1983) and many others on political independence of the central bank to show that these results are also applicable to a macro-prudential regulator. We should note that we have abstracted from considering the potential synergies that may arise in having dual mandate institutions. For instance, benefits from information sharing and use of central bank expertise may mitigate the welfare losses we have shown may arise (see Nier, Osinski, J´acome and Madrid (2011)), although information sharing would also benefit fiscal and monetary interactions. However, we have also abstracted other aspects that could exacerbate the welfare loss such as loss in reputation.


We consider macro-prudential regulation and monetary policy interactions to investigate the welfare implications of different institutional arrangements. In our framework, monetary policy can re-optimize following a realization of credit shocks, but macro-prudential regulation cannot be adjusted immediately after the credit shock. This feature of the model captures the ability of adjusting monetary policy more frequently than macro-prudential regulation because macro-prudential regulation is an ex-ante tool, whereas monetary policy can be used ex-ante and ex-post. In this setting, a central bank with a price and financial stability mandate does not deliver the social optimum because of a time-inconsistency problem. This central bank finds it optimal ex-ante to deliver the social optimal level of inflation, but it does not do so ex-post. This is because the central bank finds it optimal ex-post to let inflation rise to repair private balance sheets because ex-post it has only monetary policy to do so. Achieving the social optimum in this case requires separating the price and financial stability objectives.

We also consider the role of political independence of institutions, as in Barro and Gordon (1983).  Under this extension, separation of price and financial stability objectives delivers the social optimum only if both institutions are politically independent. If the central bank or the macro-prudential regulator (or both) are not politically independent, they would not achieve the social optimum. Numerical analysis in our model suggest however, that in most cases a non-independent macro-prudential regulator (with independent monetary authority) delivers a better outcome than a non-independent central bank in charge of both price and financial stability.

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