Financial stability, wealth effects and optimal macroeconomic policy combination in the United Kingdom: A new-Keynesian dynamic stochastic general equilibrium framework

Junjie Wu,David Mcmillan,Milton Yago,Alaa M Soliman,Muhammad Ali Nasir

doi:10.1080/23322039.2015.1136098

Abstract

This study derives an optimal macroeconomic policy combination for financial sector stability in the United Kingdom by employing a New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) framework. The empirical results obtained show that disciplined fiscal and accommodative monetary policies stance is optimal for financial sector stability. Furthermore, fiscal indiscipline countered by contractionary monetary stance adversely affects financial sector stability. Financial markets, e.g. stocks and Gilts show a short-term asymmetric response to macroeconomic policy interaction and to each other. The asymmetry is a reflection of portfolio adjustment. However in the long-run, the responses to suggested optimal policy combination had homogenous effects and there was evidence of co-movement in the stock and Gilt markets.

Highlights

The basic function of macroeconomic policy is traditionally to contribute towards promoting macroeconomic stability, namely price stability and economic growth (Bank of England, 1997) without including financial market variables
Scholars argued that the price and output stabilities do not necessarily ensure financial stability and macroeconomic policy targeting alone may not produce optimal economic outcomes (Mishkin, 2011; Williams, 2012), the financially augmented monetary policy (Taylor Type rules) could help to reduce economic fluctuations (Cúrdia & Woodford, 2011), and asset prices and leverage of agents should be in the sight of policymakers (Blanchard, Dell’Ariccia, & Mauro, 2010)
Technology shocks to stock and bond As the main theme of our study is macroeconomic policy combination effects, first we present the responses of the financial sector and monetary policy to an exogenous fiscal policy (Government Spending) shock

Summary

Introduction

The basic function of macroeconomic policy is traditionally to contribute towards promoting macroeconomic stability, namely price stability and economic growth (Bank of England, 1997) without including financial market variables. Scholars argued that the price and output stabilities do not necessarily ensure financial stability and macroeconomic policy targeting alone may not produce optimal economic outcomes (Mishkin, 2011; Williams, 2012), the financially augmented monetary policy (Taylor Type rules) could help to reduce economic fluctuations (Cúrdia & Woodford, 2011), and asset prices and leverage of agents should be in the sight of policymakers (Blanchard, Dell’Ariccia, & Mauro, 2010). Before the 2007–2009 financial crisis, Dixit and Lambertini (2003) already recommended that the coordination between fiscal and monetary authorities can achieve desirable economic outcomes. They coined the term “Symbiosis” which can be tracked back to Tinbergen’s (1953) Principle. Even in some studies incorporating policy combinations, the discussions covered the EU region and the real economy (examples see, Jansen, Li, Wang, & Yang, 2008; Semmler & Zhang, 2003) and were rare in the UK context

Objectives

Findings

Conclusion