The Macroprudential Toolkit: Effectiveness and Interactions

We use a DSGE model with financial frictions and with macroprudential limits on both banks and mortgage borrowers, in the form of capital requirements and maximum debt-service ratios. We then examine: (i) the impact of different combinations of macroprudential limits on key macroeconomic 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 on banks are the optimal tool when faced with a financial shock, as they nullify the effects of financial frictions and reduce the effects of the shock on the real economy. Instead, limits on mortgage debt-service ratios are optimal following a housing demand shock, as they disconnect the housing market from the real economy, reducing the volatility of inflation. Hence, no policy on its own is sufficient to deal with a wide range of shocks.