Interactions between monetary and macroprudential policies in the transmission of discretionary shocks

Abstract

After the 2008 international financial crisis, monetary authorities worldwide have assigned more importance to financial stability, in addition to price stability. The objective of this paper is to assemble a Dynamic Stochastic General Equilibrium (DSGE) model with financial frictions to investigate how discretionary shocks on monetary and macroprudential policies are transmitted to banks and real sector of the economy and how these policies interact between themselves. We simulated the effects of shocks on interest rate, reserve requirements, and capital requirements on the dynamics of the Brazilian economy. We also performed a sensitivity analysis of the transmission mechanisms to alternative settings of the monetary and macroprudential policies. The major findings indicated that, despite the recessionary effects on credit and output, contractionist shocks that are fully repassed to the cost of credit lead to increase in spread and banking profits, raising capital buffer and favoring financial stability. From a monetary perspective, although the transmission of interest rate shock is effective on inflation, shocks in either reserve requirements or capital requirements also affect output and inflation. Thus, monetary and macroprudential policies might be used as supplement for achieving economic and financial stability.