Central Bank Independence and Macro-Prudential Regulation Kenichi Ueda and Fabián Valencia IMF FinLawMetrics Conference, Bocconi University, June 21-22, 2012

Motivation A growing literature of macro models with financial frictions advocates the use of macro- prudential regulation (e.g. Bianchi (2010), Jeanne and Korinek (2010), etc). Implementing macro-prudential policy requires, among others, the optimal institutional design. There is an intense debate about the desirability of formally assigning the central bank with the responsibility of financial stability.

This paper We extend the central bank independence literature pioneered by Kydland and Prescott (1977) and Barro and Gordon (1983). Output stability and price stability Time-inconsistency problem and political pressures Independence of monetary authority from the rest of the government This paper adds financial stability. Output stability, price stability, and financial stability New time inconsistency problem Separation of monetary authority and financial stability authority from each other Independence of monetary authority and financial stability authority from the rest of the government

Main features Regulation cannot change frequently, whereas monetary policy can. New time inconsistency problem in a simple two stage setup. First stage: the policymakers make monetary policy and macro-prudential regulation decisions. Second stage: monetary policy decisions can be fine-tuned after the realization of a credit shock, but the regulation cannot.

Main finding A dual-mandate (price and financial stability) central bank is not optimal because of the new time inconsistency problem. In the second stage, the dual-mandate central bank has only one tool, monetary policy, to achieve financial and price stability. This central bank has the ex post incentive to reduce the real burden of private debt through inflation. Separation of two authorities is better.

Modeling Linkages Credit growth Inflation Output Nominal debt Debt / GDP ratio

Loss Function Similar to conventional loss function in the literature (Carlstrom et al., 2010, Curdia and Woodford, 2010). Frictionless economy only output matters With price stickiness even with the same outputs, welfare varies with inflation With financial friction even with the same outputs and inflation, available credit matters.

Loss Function (technical) Second order Taylor expansion at the steady state First derivative terms equal to zero b/c FOC Only second derivative terms remain Cross derivative terms are zero due to conventional assumptions Carlstrom et al: separable utility in credit goods and non- credit goods Curdia and Woodford: Credit constraint independent from inflation

Social Planner Minimize the loss function with three terms Controlling expectations a priori: SP cannot generate unexpected inflation First stage: choose zero (expected) inflation Second stage: choose zero inflation by monetary policy to offset unexpected credit growth.

Dual Mandate Central Bank Minimize loss function with two terms Given peoples expectations on inflation, outputs, and credit growth. In the first stage, two tools for two objectives: zero expected inflation, the same as the SP. In the second stage, one tool for two objectives (not considering effects on outputs): less than fully offsetting the effect of credit growth on inflation. CB tries to make unexpected inflation. Unexpected positive credit growth positive inflation

Private Debt Monetization The level of equilibrium inflation depends on the relative importance of the price and financial stability objectives. The overall welfare loss stems from the variance of credit shocks because the expected inflation is still zero. In environments where credit growth is highly volatile, our result is particularly relevant.

Separate Authorities Monetary authority minimizes Financial stability authority minimizes One tool for one objective. Optimum SPs loss function does not include the cross derivatives (additively separable over three objectives). Separate maximization gives the same outcome.

Sub finding We also consider political pressures, as in Barro and Gordon (1983) the same result Monetary authority that is not independent from the rest of the government will use the monetary policy tool to generate too much expansions. Macro-prudential authority that is not independent form the rest of the government will use the regulation to generate too much growth. Independence from the rest of the government is as important as in Barro and Gordon.

Conclusions A dual mandate central bank has a distorted incentive to lower the real burden of private sector debt. Separation of monetary authority and financial stability authority delivers the social optimum. If the central bank and the macro-prudential regulator are not politically independent, they would not achieve the optimum. Independence of monetary authority and financial stability authority from the rest of the government. Caveats: synergies from combining expertise and improving information sharing more complex loss function with large shocks (not around steady state) – this applies to almost all the existing models better modeling of financial stability in macro models