By Stephen Millard, Margarita Rubio and Alexandra Varadi
We use a DSGE model with financial frictions, leverage limits on banks, loan to value (LTV) limits and debt‑service ratio (DSR) limits on mortgage borrowing to examine: i) the effects of different macroprudential policies on key macro aggregates; ii) their interaction with each other and with monetary policy; and iii) their effects on the volatility of key macroeconomic variables and on welfare. We find that capital requirements can nullify the effects of financial frictions and reduce the effects of shocks emanating from the financial sector on the real economy. LTV limits, on their own, are not sufficient to constrain household indebtedness in booms, though can be used with capital requirements to keep DSRs under control. Finally, DSR limits lead to a significant decrease in the volatility of lending, consumption and inflation, since they disconnect the housing market from the real economy. Overall, DSR limits are welfare improving relative to any other macroprudential tool.
This paper shows nicely that central banks have other useful tools in their hand to manage business cycles. This is only a first step though. One still needs to show that a policy maker can work with them efficiently and practically, for example that they can be changed in time for good effect. Also, when the economy is in something like a corner solution like now, do these tools still work (or work even better)?