Combining monetary policy and prudential regulation: an agent-based modeling approach

Abstract

This paper explores the interaction between monetary policy and prudential regulation in an agent-based modeling framework. Firms borrow funds from the banking system in an economy regulated by a central bank. The central bank carries out monetary policy, by setting the interest rate, and prudential regulation, by establishing the banking capital requirement. Different combinations of interest rate rule and capital requirement rule are evaluated with respect to both macroeconomic and financial stability. Several relevant policy implications were drawn. First, the efficacy of a given capital requirement rule or interest rate rule depends on the specification of the rule of the other type it is combined with. More precisely, less aggressive interest rate rules perform better when the range of variation of the capital requirement is narrower. Second, interest rate smoothing is more effective than the other interest rate rules assessed, as it outperforms those other rules with respect to financial stability and macroeconomic stability. Third, there is no tradeoff between financial and macroeconomic stability associated with a variation of either the capital requirement or the smoothing interest rate parameter. Finally, our results reinforce the cautionary finding of other studies regarding how output can be ravaged by a low inflation targeting.

Appendix: Parameters and initial conditions

Number of Monte Carlo simulations		$100^\mathrm{a}$
Symbol	Meaning	Value
Parameters
N	Number of firms	500
$\alpha$	Production parameter (see Eq. 1)	3
$\beta$	Production parameter (see Eq. 1)	0.7
$t_D$	Duration of debts (in periods)	10
$\eta$	Labor productivity	1
$\psi$	Real wage lower limit parameter (see Eq. 3)	0.95
$\delta$	Fraction of profits distributed as dividends	0.25
$\tau$	Tax rate	0.25
$\phi$	Markup sensitivity to a change in market share (see Eq. 6)	0.2
$\lambda$	Leverage sensitivity to a change in demand (see Eq. 10)	1
$i^{B}$	Base interest rate	0.02
k	Capital requirement ratio	0.08
$\gamma$	Risk premium parameter (see Eq. 11)	0.02
Initial conditions
$NW_{i,0} ^\mathrm{b}$	Firms’ initial net worth	$NW_{i,0} \sim N\left( {10,2} \right)$
$\mu _{i,0} ^\mathrm{c}$	Firms’ initial markup	$\mu _{i,0} \sim N\left( {0.15,0.03} \right)$
$w_0$	Initial nominal wage	1
$l_{i,0}^*$	Firms’ initial leverage target	$l_{i,0}^*\sim U\left( {0.01,3} \right)$
$s_{i,0}$	Firms’ initial market share	${NW_{i,0} }/{\sum {NW_{i,0} } }$
$NW_o^B$	Banking system’s initial net worth	$2k\sum {NW_{i,0} }$
$\Gamma _0$	Government initial surplus	10,000
Policy rules parameters
$r^{*}$	Equilibrium real interest rate	0.02
${\pi }^{T}$	Inflation target	0
$\chi$	Smoothing parameter of the interest rate rule	$0.5^\mathrm{d}$
${\theta }_{1}$	Sensitivity of the interest rate to the inflation	0.5
${\theta }_{2}$	Sensitivity of the interest rate to the output gap	0.5
${\theta }_{3}$	Sensitivity of the interest rate to the credit-to-output gap	$[0.1, 0.2, 0.5]^\mathrm{e}$
${\theta }^{C}$	Sensitivity of the capital requirement to the credit-to-output gap (UNB and CRS rules) or to the credit gap (CGR rule)	0.5

1. $^\mathrm{a}$ For the policy analysis in Sect. 4.1: 200 simulations
2. $^\mathrm{b}$ Initial net worth is never set below 1
3. $^\mathrm{c}$ Initial markup is never set below 1%
4. $^\mathrm{d}$ Out of the IRS rule: zero
5. $^\mathrm{e}$ Out of the LAW rule: zero