CFCM 15/10: Monetary and Macroprudential Policies under Fixed and Variable Interest Rates

Abstract

In recent years, especially during the period of the Great Moderation, monetary policy had been seen as a very powerful tool to stabilize the economy. However, in the aftermath of the crisis, new experiences have revealed that this statement is not true for all cases or under all circumstances. First of all, the effectiveness of monetary policy may depend on structural factors in the economy. In particular, there may be institutional features, especially in housing markets, that are country specific and that may affect the optimal conduct of policies. One source of heterogeneity, which can be crucial, is the structure of mortgage contracts. Mortgage contracts in an economy can be fixed or variable rate, and the proportion of each type of mortgages varies from country to country. The link between the policy rate and fixed rates is weaker, since the latter are more connected to longer-term rates, and thus, in this case, monetary policy is less effective. On the other hand, with the crisis, the centre of policy and academic discussions has been how to ensure a more stable financial system: a macroprudential approach to prevent the economy from situations in which problems in the financial sector are transmitted to the real sector and vice-versa. It is debatable that monetary policy alone can achieve this goal; it may need the help of other tools that help avoiding excessive credit growth. The remaining question is the following: Does the mortgage structure of the economy affect the ability of monetary policy to enhance financial stability?

In this Nottingham School of Economics working paper, Margarita Rubio sheds some light on this issue. She analyses the ability of monetary policy to stabilize financial markets under two different scenarios: when the prevalent mortgage rate in the economy is variable and when it is fixed. Results show that macroprudential policies increase welfare regardless of the mortgage structure prevalent in the economy. Nevertheless, when mortgages are variable rate, a separate macroprudential policy combined with monetary policy is preferable to letting monetary policy alone stabilize financial markets. Interestingly for the fixed rate case, in which monetary policy is less effective to stabilize the macroeconomy, it is a more powerful tool to stabilize the financial system.

CFCM Discussion Paper 15/10, Monetary and Macroprudential Policies under Fixed and Variable Interest Rates by Margarita Rubio

Download the PDF of this paper

Authors

Margarita Rubio

View all CFCM discussion papers | View all School of Economics featured discussion papers