Abstract:

How should policymakers adapt their macroprudential and monetary policies when the fi- nancial sector is vulnerable to belief-driven boom-bust cycles? I develop a model in which fi- nancial intermediaries are subject to collateral constraints, and that features a general class of deviations from rational expectations. I show that distinguishing between the drivers of behav- ioral biases matters: when biases are a function of equilibrium asset prices, new externalities arise, even in models that do not have any room for policy in their rational benchmark. I build on this theory to examine policy implications. First, the policymaker should use counter-cyclical capital buffers and time-varying loan-to-value ratios. These restrictions must be strengthened in times of over-optimism, as well as when the regulator is concerned that over-pessimism will arise in a future crisis. Second, uncertainty about the precise extent of behavioral biases in finan- cial markets increases the incentives for the planner to act early. Finally, when biases depend on asset prices, an additional instrument is needed to act directly on asset prices. I study the use of monetary policy for this objective, and show that “leaning against the wind” can be desirable even when these macroprudential tools are unconstrained. The policymaker raises interest rates when there is a fear that high asset prices today, even if entirely warranted by fundamentals, can trigger extrapolation later on. Conventional monetary policy however loses power in normal times when agents expect the central bank to lean against the wind in the future.