By Stefan Laséen, Andrea Pescatoriand Jarkko Turunen
We introduce time-varying systemic risk (à la He and Krishnamurthy, 2014) in an otherwise standard New-Keynesian model to study whether simple leaning-against-the-wind interest rate rules can reduce systemic risk and improve welfare. We find that while financial sector leverage contains additional information about the state of the economy that is not captured in inflation and output leaning against financial variables can only marginally improve welfare because rules are detrimental in the presence of falling asset prices. An optimal macroprudential policy, similar to a countercyclical capital requirement, can eliminate systemic risk raising welfare by about 1.5%. Also, a surprise monetary policy tightening does not necessarily reduce systemic risk, especially during bad times. Finally, a volatility paradox à la Brunnermeier and Sannikov (2014) arises when monetary policy tries to excessively stabilize output.
I think it is no surprise that adding a policy objective requires adding a policy instrument. The question here is whether the new instrument messes up the others in a major way. If things are difficult with a double mandate, imagine what this becomes with a triple one.