Ecb wp2155 en

Working Paper Series
Alejandro Van der Ghote Coordinating monetary and

financial regulatory policies
No 2155 / June 2018
Disclaimer: This paper should not be reported as representing the views of the European Central Bank
(ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.
Latest version available here
Abstract
How to conduct macro-prudential regulation? How to coordinate monetary policy

and macro-prudential policy? To address these questions, I develop a continuous-
time New Keynesian economy in which a …nancial intermediary sector is subject to
a leverage constraint. Coordination between monetary and macro-prudential policies
helps to reduce the risk of entering into a …nancial crisis and speeds up exit from the
crisis. The downside of coordination is variability in in‡ation and in the employment
gap.
How to conduct macro-prudential regulation? How to coordinate monetary policy
and macro-prudential policy? To address these questions, we develop a continuous-
tJEL Classi…cation: E31, E32, E44, E52, E61, G01How to coordinate monetary policy
aKeywords: Monetary Policy, Macro-prudential Policy, Policy Coordination
ECB Working Paper Series No 2155 / June 2018 1

Non-technical Summary
The Global Financial Crisis of 2008 has called into question the conduct of monetary
policy. Before the crisis, monetary policy in many industrial countries adjusted the short-
term nominal interest rate to maintain price stability, sustain full employment or achieve
a combination of both. After the crisis, a debate began in academic and policy circles
concerning whether monetary policy should also tackle …nancial stability risks. The crisis
has also prompted the development of macro-prudential policy which consists of a battery
of taxes or quantity restrictions on asset positions with the speci…c aim of safeguarding
…nancial stability. Should monetary policy and macro-prudential policy coordinate to
jointly respond to macroeconomic and to …nancial stability concerns? And if so, should
they coordinate all the times, only during times of …nancial turmoil and deep contraction in
economic activity, or only during times of …nancial booms and rapid economic expansions?
What are the costs and bene…ts of coordinating monetary policy and macro-prudential
policy optimally throughout the economic cycle?
In this paper, I develop a dynamic macroeconomic model of …nancial intermediation
that is suitable for studying coordination between monetary policy and macro-prudential
policy over the multiple phases of the economic cycle. The model economy I develop is a
continuous-time New Keynesian economy in which a …nancial intermediary sector is subject
to an incentive-compatible (IC) leverage constraint. The IC constraint occasionally binds
in equilibrium, giving rise to an endogenous economic cycle that has the following three
features. First, it ‡uctuates continuously in accord with the continuous ‡uctuations in
the intermediaries’ aggregate capitalization and in the gap between potential and actual
aggregate output. Second, it recurrently transitions along the entire continuum, from good
phases of sound …nancial conditions and high economic activity, i.e. “normal times”, to
extremely bad phases of severe …nancial distress and deep economic recession, i.e. “crisis
times.” And third, it reacts to changes in the phase-contingent rules for monetary policy
and macro-prudential policy.
To study coordination between monetary policy and macro-prudential policy, I contrast
the optimal phase-contingent rules for such policies under the policy mandates that are
typically discussed in policy circles. I refer to these mandates as the traditional and the co-
ordinated mandate. Under the traditional mandate, monetary policy and macro-prudential
policy have separate objectives and interact strategically while taking each other’s policy
rules as given. The objective of monetary policy is to keep in‡ation and the employment

gap stable at their structural levels (i.e., macroeconomic stability); while the objective of
macro-prudential policy is to curb excessive ‡uctuations in asset prices and intermediary
aggregates that result from the occasionally binding IC leverage constraint (i.e., …nancial
stability). Under the coordinated mandate, monetary policy and macro-prudential policy
share a joint objective, which consists of maximizing social welfare and is consistent with
the conjunction of individual objectives under the traditional mandate.
The paper’s main result is that coordination between monetary policy and macro-
prudential policy generically improves …nancial but worsens macroeconomic stability. In
the baseline calibration, in terms of annual consumption equivalent, gains from improving
on …nancial stability amount to 0:11% while losses from worsening on macroeconomic
stability amount to 0:04%: Social welfare gains amount to 0:07%:

1 Introduction
The Global Financial Crisis of 2008 has called into question the conduct of monetary policy.
Prior to the crisis, traditionally, monetary policy adjusted the short-term nominal interest
rate to maintain price stability and sustain full employment. After the crisis, a debate
began in academic and policy circles (BIS 2014, 2016; Bernanke 2015; Svensson 2016)
concerning whether monetary policy should also respond to …nancial stability concerns.
The crisis has also fostered the development of new policy instruments whose primary
objective has been to safeguard …nancial stability. Those policy instruments are usually
referred to as macro-prudential policies and usually consist of quantity restrictions that
target the sector level, such as payment-to-income ratios (PTI) and loan-to-value ratios
(LTV) on households, and liquidity coverage ratios (LCR) and capital requirements (CR)
on …nancial institutions.
Should monetary policy and macro-prudential policy coordinate to jointly respond to
macroeconomic and to …nancial stability concerns? And if so, should they coordinate all
the times, only during times of …nancial turmoil and deep contraction in economic activity,
or only during times of …nancial booms and rapid economic expansions? What are the
costs and bene…ts of coordinating monetary policy and macro-prudential policy optimally
throughout the economic cycle? While the …rst question has received considerable attention
in the literature, the second and the third have remained largely ignored. This paper …lls
that gap by addressing the three questions together.
The paper’s …rst contribution is to develop a tractable model economy that is suitable
for studying coordination between monetary policy and macro-prudential policy over the
multiple phases of the economic cycle. The model economy I develop is a continuous-
time New Keynesian economy in which a …nancial intermediary sector is subject to an
incentive-compatible (IC) leverage constraint. The IC constraint occasionally binds in
equilibrium, giving rise to an endogenous economic cycle that has the following three
features. First, it ‡uctuates continuously in accord with the continuous ‡uctuations in
the intermediaries’ aggregate capitalization and in the gap between potential and actual
aggregate output. Second, it recurrently transitions along the entire continuum, from good
phases of sound …nancial conditions and high economic activity, i.e. “normal times”, to
extremely bad phases of severe …nancial distress and deep economic recession, i.e. “crisis
times.”And third, it reacts to changes in the phase-contingent rules for monetary policy and
macro-prudential policy. The continuous-time framework adopted for the model economy

is useful for capturing the highly nonlinear dynamics in the economic cycle associated with
…nancially constrained agents (Brunnermeier and Sannikov 2014 and Moll 2014).
In the model economy, monetary policy sets the benchmark short-term nominal interest
rate while macro-prudential policy sets a state-contingent capital requirement on …nancial
intermediaries. Under a traditional (and non-coordinated) mandate, monetary policy and
macro-prudential policy have separate objectives and interact strategically while taking
each other’s policy rules as given. The objective of monetary policy is to keep in‡ation and
the employment gap stable at their structural levels (i.e., macroeconomic stability); while
the objective of macro-prudential policy is to curb excessive ‡uctuations in asset prices and
intermediary aggregates that result from the occasionally binding IC leverage constraint
(i.e., …nancial stability).1 Under a coordinated mandate, monetary policy and macro-
prudential policy share a joint objective, which consists of maximizing social welfare and
is consistent with the conjunction of individual objectives under the traditional mandate.
The paper’s second contribution is to derive optimal monetary policy and macro-
prudential policy under each mandate, and to quantitavely assess the social welfare gains
of the coordinated mandate over the traditional mandate. The contrast of optimal pol-
icy rules between mandates points out the direction policy should pursue to exploit those
gains.
Under the traditional mandate, monetary policy mimics the natural rate, while macro-
prudential policy replicates the constrained-e¢ cient capital requirement of the counterfac-
tual economy, in which nominal prices are fully ‡exible. The natural rate is the short-term
real interest rate that accommodates aggregate demand in the manner required to keep
in‡ation and the employment gap stable at their structural levels of zero. The constrained-
e¢ cient capital requirement of the counterfactual ‡exible price economy restricts interme-
diary leverage occasionally, only when …nancial intermediaries, on aggregate, are average
capitalized relative to the total wealth in the economy (and the IC leverage constraint
occasionally binds locally).
Under the coordinated mandate, monetary policy deviates from the natural rate, while
macro-prudential policy relaxes the capital requirement relative to the traditional man-
1
Caballero and Krishnamurthy (2001), Lorenzoni (2008), Bianchi and Mendoza (2010), Jeanne and Ko-
rinek (2010), Bianchi (2011), Korinek (2011) and Dávila and Korinek (2017), among others, show that
economies with ocassionally binding …nancing constraints and/or incomplete …nancial markets generically
are constrained ine¢ cient. In such economies, pecuniary externalities that operate through asset prices
and/or asset returns exist and, in general, generate excessive ‡uctuations in intermediary and macroeco-
nomic aggregates relative to the constrained e¢ cient allocation.

date. Monetary policy deviates in accord with the prescriptions of the Greenspan put and
of leaning against the wind, but relies more heavily on the prescriptions of the latter. The
Greenspan put prescribes over stimulating economic activity beyond the ‡exible price econ-
omy benchmark during times of …nancial distress (Blinder and Reis 2005, Svensson 2016),
while leaning against the wind prescribes slowing economic activity down beyond the same
benchmark, but during times of (seemingly) sound …nancial conditions (Svensson 2016).
Through the lens of the model economy, times of …nancial distress occur when …nancial
intermediaries, on aggregate, are poorly capitalized — and the aggregate share of interme-
diated capital is way below its …rst-best level — while times of sound …nancial conditions
occur when …nancial intermediaries on aggregate are average to richly capitalized.
Relative mimicking the natural rate, deviating from the natural rate in the manner
described above helps to improve …nancial stability, but nonetheless generates also macro-
economic instability. It helps to improve on …nancial stability because it temporarily boosts
economic activity and the intermediation margin precisely when …nancial intermediaries,
on aggregate, are poorly capitalized and need the temporary stimulus the most. Leaning
against the wind is particularly useful for further boosting the intermediation margin be-
yond the stimulus provided by the Greenspan put: Because the price of capital investments
is forward-looking, slowing economy activity down in times of sound …nancial conditions
puts downward pressure on the price of capital investment in times of …nancial distress,
which in turn puts upward pressure on the rate of return of capital investments and on
the intermediation margin when …nancial intermediaries are poorly capitalized. Leaning
against the wind is not particularly useful for restricting intermediary leverage during times
of sound …nancial conditions, because for that reason there is a capital requirement. The
capital requirement softens relative to the traditional mandate because a binding capital
requirement places intermediary leverage and the aggregate share of intermediated capi-
tal below their potential capacities in the short term. Softening the capital requirement
is evidence that in the model economy, monetary policy and macro-prudential policy are
substitutes as far as …nancial stability is concerned.
To quantify the social welfare gains of the coordinated mandate over the traditional
mandate, I calibrate the model economy. In the baseline calibration, in terms of annual
consumption equivalent, gains from improving on …nancial stability amount to 0:11% while
losses from worsening on macroeconomic stability amount to 0:04%: Social welfare gains
amount to 0:07%: Losses in macroeconomic instability remain of second-order importance
relative to gains in …nancial stability provided deviations from the natural rate remain su¢ -

ciently small. This is because under the traditional mandate, in‡ation and the employment
gap remain stable at their structural levels, while the aggregate share of intermediated cap-
ital, in general, does not remain stable at its …rst-best level.
Related Literature This paper relates to a body of literature that studies the interac-
tion of and coordination between monetary policy and macro-prudential policy. A group
of papers in this literature — for instance, Angelini et al. (2012) and Gelain and Ilbas
(2017), among others — speci…es policy mandates that are grounded in macroeconomic
aggregates (such as in‡ation, output gap, credit growth, and so on), but not necessarily
grounded in social welfare. Another group of papers in this literature — e.g., Woodford
(2011), Bailliu et al. (2015) and Carrillo et al. (2017), among others — restricts attention
to simple policy rules such as Taylor rules. This paper di¤erentiates from the papers in
these two groups by considering policy mandates that are grounded in social welfare, and
general policy rules whose only restriction is to be polynomial functions of the aggregate
state.
De Paoli and Paustian (2017), Collard et al. (2017), and Farhi and Werning (2016)
follow a similar approach to this paper concerning the speci…cation of policy mandates
and policy rules.2 The main di¤erence with respect to De Paoli and Paustian (2017) and
Collard et al. (2017) is that in their model economy the …nancing constraint always binds.
Occasionally binding …nancing constraints are critical for generating economic cycles with
multiples phases and hence for analyzing the e¤ects of policies that are truly prudential
in nature. The main di¤erence with respect to Farhi and Werning (2016) is that for
justifying macro-prudential policies, they consider both aggregate demand externalities
and pecuniary externalities while I consider only pecuniary externalities.
This paper also relates to a body of literature that studies whether monetary policy
should lean against the wind of credit booms and …nancial imbalances. Most of the papers
in this literature — for instance, Svensson (2016), Ajello et al. (2016), and Gourio et al.
(2017), among others — consider an economic cycle that has only two stages: “normal
times” and “crisis times.” A notable exception is Filardo and Rungcharoenkitkul (2016),
who introduce an endogenous economic cycle with an arbitrarily large number of stages
into an otherwise standard quadratic-function-loss model for the stabilization problem of
monetary policy. The main di¤erence with respect to those papers is that, in this paper, the
2
To be more precise concerning the speci…cation of the policy rules, none of those papers place any
restrictions on their domain.

economic cycle is microfounded, being the microfoundation based on the leverage behavior
of …nancial intermediaries; in constrast, those papers model the economic cycle in reduced-
form. The microfoundation of the economic cycle in this paper is critical for assessing the
bene…ts of leaning against the wind.
This paper relates also to a body of literature that studies optimal macro-prudential
policy in the context of ‡exible price economies. The theoretical foundation for macro-
prudential policy is to correct externalities and general failures in …nancial markets that
may pose threats to the stability of the …nancial system as a whole (Hanson et al. 2011).
This paper contributes to this literature by pointing out a new type of pecuniary external-
ity, which di¤ers from existing distributive and binding-constraint externalities identi…ed
by Dávila and Korinek (2017). This new type of pecuniary externality, which I refer to
as the dynamic pecuniary externality, arises when individual agents can also a¤ect the dy-
namic behavior of asset prices and/or asset returns. Concerning the microfoundation of
pecuniary externalities, in this paper pecuniary externalities follow from the combination
of moral hazard problems in credit markets and incomplete …nancial contracts (Gertler and
Karadi 2011 and Gertler and Kiyotaki 2010), whereas in Di Tella (2017a, 2017b), among
others, pecuniary externalities follow exclusively from moral hazard problems. The combi-
nation of …nancial frictions adopted in this paper is critical for generating the occasionally
binding IC leverage constraint discussed above. Regarding the behavior of optimal macro-
prudential policy, this paper shares with Bianchi and Mendoza (2010) and Bianchi (2011)
the result that levered agents should be regulated when, on aggregate, they are average
capitalized relative to total wealth in the economy. The main di¤erence with respect to
those papers is that they consider a levered household sector while I consider a levered
…nancial intermediary sector.
On methodological grounds, my model economy builds on the works of Calvo (1983),
Brunnermeier and Sannikov (2014, 2016), Gertler and Karadi (2011), Gertler and Kiy-
otaki (2010), and Maggiori (2017). The main di¤erence with respect to Brunnermeier and
Sannikov (2016) is that in my model, money serves the role of a unit of account, whereas
in their model money serves the role of a store of value. As in Drechsler et al. (2017),
my model economy is a continuous-time production economy with nominal rigidities and
…nancial frictions; in constrast to their paper, however, in my model nominal rigidities
are grounded in the sluggish nominal price adjustments of …rms, as in the New Keynesian
framework.
Layout Section 2 develops the model economy. Section 3 solves for the competitive

equilibrium of the model economy. Section 4 de…nes the policy mandates. Section 5
derives optimal monetary policy and optimal macro-prudential policy under the traditional
mandate. Section 6 repeats the same exercise, but for the coordinated mandate. Section
7 quantitatively assesses the costs and bene…ts of the coordinated mandate relative to the
traditional mandate. Section 8 concludes.
2 The Model
The model is a continuous-time New Keynesian economy in which a …nancial intermediary
sector is subject to a leverage constraint. The speci…cation for the sluggish nominal price
adjustments of …rms, which is the key feature of the New Keynesian framework, follows
the work of Calvo (1983). The setup of …nancial intermediation builds on the works
of Brunnermeier and Sannikov (2014), Gertler and Karadi (2011), Gertler and Kiyotaki
(2010), and Maggiori (2017).
2.1 Production in Goods Markets and Price-setting Behavior

In the model economy, there is a continuum of …rms that produce a continuum of interme-
diate good varieties yj;t ; with j 2 [0; 1] ; using labor lj;t and capital services kj;t as inputs.
Each …rm produces a single intermediate good variety using a Cobb-Douglas production
technology:
1
yj;t = At lj;t kj;t ; (1)
that has a common labor share of output and a common productivity factor At across
j 2 [0; 1] : The productivity factor At is exogenous and evolves stochastically according to
the Ito process:
dAt =At = A dt + A dZt ; (2)
with drift process A and di¤usion process A > 0; being fZt 2 R : t 0g a standard
Brownian process de…ned on a …ltered probability space ( ; F; P ) : Intuitively, the Brown-
ian shock dZt is an i.i.d. shock to the growth rate of aggregate productivity that is normally
(0; 1) distributed. The shock dZt is the only source of risk in the model economy.
To produce their intermediate good variety, …rms hire labor and rent capital services
in competitive markets at the real wage rate of wt and at the real rental rate of rk;t : Firms
combine labor and capital services optimally to minimize their production costs xt (yj;t ) ;

which are:
1
1 wt rk;t
xt (yj;t ) = yj;t : (3)
At 1
In intermediate goods markets, …rms compete monopolistically with each other re-
setting their nominal price pj;t sluggishly according to Calvo (1983) pricing. Each …rm
"
faces an indirect demand function yd;t (pj;t ) (pj;t =pt ) yt ; which follows from a constant-
elasticity-of-substitution (CES) aggregator,
Z 1 " 1
"
" 1
"
yt = yj;t dj ; (4)
0
that aggregates fyj;t gj2[0;1] into a …nal consumption good yt optimally given fpj;t gj2[0;1] ,
being " > 1 the elasticity of substitution across intermediate goods in the CES aggregator.
The nominal price pt measures the minimum cost required to produce one unit of the …nal
consumption good; it equals the consumer price index:
Z 1
1
1 "
pt = p1j;t " dj ; (5)
0
and it can therefore be interpreted as the aggregate price level.
Price-setting Problem In the Calvo (1983) pricing speci…cation, …rms can reset their
nominal price occasionally, only when they are hit by an idiosyncratic Poisson shock that
has a common arrival rate across …rms.3 When they have the opportunity to reset their
nominal price, …rms maximize the present discounted value of the pro…ts ‡ows accrued
from …xing their nominal price at pj;t :
Z 1
(s t) s pj;t yd;s (pj;t )
max Et e (1 ) xs [yd;s (pj;t )] ds : (6)
pj;t >0 t t ps
I assume that …rms discount future pro…t ‡ows with the Stochastic Discount Factor (SDF)
of households — weighted, of course, by the survival density function e (s t) of their
t
…xed nominal price. The SDF t is an endogenous object to be determined in equilibrium.
The coe¢ cient is an advalorem sales subsidy on …rms.
3
Additionally, in the Calvo (1983) pricing speci…cation, …rms pay no “menu” cost for resetting their
nominal price, and …rms that cannot reset their price must accommodate their indirect demand at the
prevailing market prices.

Optimal Prices in Goods Markets Firms that have the opportunity to reset their
nominal price set the same optimal price p ;t ; because their price-setting problems (6) are
identical. The optimal real price p ;t =pt is the product of two factors:
R1 (s t)
" Et t e s
t
xs [yd;s (pt )] ds
p ;t =pt = R pt yd;s (pt )
: (7)
(1 ) (" 1) Et 1 e (s t) s
ds
| {z } t t ps
=1
The …rst factor is the product of a sales subsidy multiplier 1= (1 ) and a distortion
coe¢ cient from monopoly pricing "= (" 1) : I impose that = 1= (" 1) to eliminate
the distortions from monopoly pricing. This implies that …rms set competitive prices.
The second factor is the ratio of the present discounted value of production costs to that
of sales revenues (gross of sales subsidies) of a hypothetical …rm that charges a nominal
price equal to the aggregate price level pt : The second factor would reduce to the spot
marginal production costs xt (yj ) =yj if …rms could instead reset their price continuously,
i.e., 1= ! 0:
2.2 Investment Portfolios and Financial Intermediation

In the model economy, there is also a continuum of …nancial intermediaries and a continuum
of households. Households are the residual claimants of the pro…ts ‡ows that …rms make
and of the dividends ‡ows that …nancial intermediaries pay out.
To create a meaningful role for …nancial intermediation, I assume that …nancial interme-
diaries have a comparative advantage relative to households for providing capital services
to …rms. The capital services that …rms use in production are made out of physical capital,
which is a real asset in positive …xed supply. Financial intermediaries transform physi-
cal capital into capital services at a one-to-one rate whereas households do it at a rate
ah < 1: In Appendix A, I show that the productivity gap 1 ah can be rationalized as a
productivity di¤erence that originates from a moral hazard problem in equity markets.4
4
More precisely, in Appendix A, the structure of equity markets and the moral hazard problem in equity
markets are such that: (i) neither …nancial intermediaries nor households directly hold physical capital; (ii)
the direct holders of physical capital (which consists of some physical capital lessors) issue equity shares
against the present discounted value of the pro…t ‡ows made from renting the capital services to …rms;
and (iii) equity shareholders (which consists of …nancial intermediaries or households) can monitor the
activities of equity issuers to induce the latter to provide net present value, having …nancial intermediaries
a comparative advantage for monitoring relative to households. The productivity gap 1 ah follows from
the comparative advantage of …nancial intermediaries for monitoring.

The productivity gap 1 ah is the only reason …nancial intermediaries provide value in the
model economy.
Physical capital is tradable, being all of the aggregate capital stock k traded in fully
liquid markets at the spot real price of qt k: By raising deposits bt from households, …nancial
intermediaries can take levered positions on physical capital qt kf;t = bt + nf;t ; beyond the
limits given by their own net worth nf;t : To create a meaningful link between aggregate
intermediary net worth and the real economy, I assume that …nancial intermediaries are
subject to a limited enforcement problem that restricts bt and qt kf;t according to:
qt kf;t = bt + nf;t Vt ; (8)
being > 1 a real number, and Vt the franchise value of the …nancial intermediary company.
The limited enforcement problem is such that …nancial intermediaries can divert a share
1= of their assets, at the expense of losing access to their intermediary company. For
this problem to be relevant, I assume that each …nancial intermediary is owned by a single
household, and that each household deposits funds with …nancial intermediaries other
than the one they own. In the IC constraint (8) ; deposits bt are also bounded from above,
because …nancial intermediaries cannot issue equity, which ensures that nf;t 0: Later in
the paper, I show that Vt vt nf;t is proportional to net worth nf;t ; with vt 1; which
delivers the linear IC constraints bt ( vt 1) nf;t and 0 qt kf;t vt nf;t ; and the
corresponding linear upper bounds on bt and qt kf;t :
Let dRe;t ; with e = ff; hg ; denote the rates on return on physical capital that …nancial
intermediaries (f ) and households (h) earn. Rates dRe;t are the sum of the speci…c dividend
yields that agents e = ff; hg obtain and the common capital gain/loss rate dqt =qt :
rk;t dqt
dRe;t [ah 1e=h + 1 1e=h ] dt + ; with e = ff; hg :
qt qt
Because dRf;t > dRh;t ; …nancial intermediaries would eventually accumulate enough net
worth to grow out of the IC constraint if they were to not pay out dividends su¢ ciently
often. To avoid that scenario, I assume that …nancial intermediaries pay out dividends
according to an idiosyncratic Poisson process that has a common arrival rate of across
them. I also assume that when …nancial intermediaries pay out dividends, they transfer
all of their net worth to the households, and that after the dividend payout, …nancial
intermediaries automatically receive a share = of the aggregate capital stock as a start-up

endowment from households. Financial intermediaries must receive a positive endowment
after paying out dividends, because without net worth they cannot issue deposits or operate.
To incorporate macro-prudential policy in the analysis, I assume that …nancial inter-
mediares are subject to an additional leverage constraint, that restricts qt kf;t according
to:
qt kf;t t nf;t ; (9)
being t 1 a common capital requirement across …nancial intermediaries. The capital

requirement t is contingent on the aggregate state and indicates the stance of macro-
prudential policy. Financial intermediaries take t as given.
2.3 Portfolio Problems

Intermediaries’ Portfolio Problem The objective of …nancial intermediaries is to
maximize the present discounted value of their dividend payouts. I assume that …nan-
cial intermediaries discount future dividend payouts with the SDF of the household t;
weighted by the probability density function e (s t) of paying out dividends. Financial
intermediaries solve the portfolio problem:
Z 1
(s t) s
Vt max Et e nf;s ds (10)
kf;t 0;bt t t
subject to : nf;t 0; (8) ; (9) ; (11) ;
with (11) being the condition that describes the evolution of the intermediary net worth,
dnf;t = dRf;t qt kf;t (it t ) bt dt; (11)
it the nominal deposit rate, and t the expected in‡ation rate. By design, deposits are
short-term nominal debt contracts that pay out a locally risk-free nominal rate of return
of it dt: I postulate that the in‡ation rate dpt =pt is locally risk-free:
dpt =pt = t dt + 0dZt ;
which implies that the real deposit rate (it t ) dt is also locally risk-free. This postulate
will be consistent with the conditions that characterize the competitive equilibrium.

Leverage Multiple and Tobin’s Q The value Vt vt nf;t is proportional to net worth
nf;t because portfolio problem (10) is linear. The marginal value of wealth vt is common to
all …nancial intermediaries and therefore can be interpreted as Tobin’s Q. In Appendix B,
I show that the value t Vt = t vt nf;t satis…es a standard Hamilton-Jacobi-Bellman (HJB)
equation, which delivers two optimality conditions.5
The …rst optimality condition is an asset pricing condition for physical capital that can
be represented accordingly:
Et [dRf;t ] (it t ) dt + Covt [d t= t + dvt =vt ; dRf;t ] 0; (12)
with equality if the leverage constraint t qt kf;t =nf;t min f vt ; tg is slack.

The LHS in (12) is the (expected) risk-adjusted excess return on capital over deposits
that …nancial intermediaries earn. When they earn a positive risk-adjusted excess return,
…nancial intermediaries strictly prefer physical capital to deposits, and take levered po-
sitions on physical capital until hitting their leverage constraint. When they earn a null
risk-adjusted excess return, …nancial intermediaries are indi¤erent between physical capital
and deposits, and are willing to take any leverage multiple 6
t: Financial intermediaries
are concerned with comovement between the percentage change in their marginal value of
wealth dvt =vt and the rate of return dRf;t (and therefore demand compensation for holding
capital risk that di¤ers from the usual compensation a representative household with an
SDF of t would demand), because they are subject to a leverage constraint.
The second optimality condition is an asset pricing condition for vt that can be repre-
sented accordingly:
~t dRn ;t +
E dt + Et [dvt =vt ] dt + Covt [d t = t ; dvt =vt ] =0; (13)
f
vt
with7
~t dRn ;t
E Et [dnf;t =nf;t ] (it t ) dt + Covt [d t= t + dvt =vt ; dnf;t =nf;t ] :
f
5
To derive the HJB equation, I conjecture that qt ; vt and t evolve stochastically according to Ito
processes. The conjecture on qt implies that dqt =qt and dRe;t are locally risky and, therefore, that …nancial
intermediaries concentrate aggregate risk in their balance sheets when they take on leverage.
6
Financial intermediaries cannot earn a negative risk-adjusted excess return; otherwise, they would not
be willing to take levered positions on physical capital.
7
The expression in (13) assumes that (it t ) dt = Et [d t = t ] : This latter condition follows from the
optimality conditions in the households’portfolio problem.

~t dRn ;t is the (expected) risk-adjusted excess return
The conditional expectation E f
on net worth over deposits that …nancial intermediaries earn. It equals the product of the
leverage multiple and the (expected) risk-adjusted excess return on capital in (12) : The
t
~t dRn ;t enters as a dividend yield component in asset pricing
conditional expectation E f
condition (13) which implies that vt can also be interpreted as a present discounted value
of the marginal pro…t ‡ows that …nancial intermediaries make. Because the value vhf;t of
a hypothetical …nancial intermediary that can invest only in deposits equals 1 (notice that
for such hypothetical …nancial intermediary hf;t = 0); vt vhf;t = 1:8
Households’ Portfolio Problem To close the model economy, I specify the portfolio
problem of households. Households choose their consumption ct ; labor supply lt ; and
investment portfolio. Households are subject to no leverage constraints. Their objective is
to maximize the present discounted value of their utility ‡ows:
Z " #
1
(s t) ls1+
Et e ln cs ds; (14)
t 1+
being the time discount rate; the weight assigned to the disutility from labor; and the
inverse of the Frish elasticity of the labor supply. Households have logarithmic preferences
for consumption, which implies that their SDF is e t =c
t t:
Households solve a standard portfolio problem, which consists of maximizing (14) sub-
ject to ct ; lt ; kh;t 0 and to the evolution of their net worth,
dnh;t = dRh;t qt kh;t + (it t) nh;t qt kh;t dt + wt lt dt + T rt dt ct dt; (15)
being nh;t the net worth of households; kh;t the position households take on physical capital;
and T rt the net transfers households receive from …rms and …nancial intermediaries. The
position nh;t qt kh;t is the funds households deposit with …nancial intermediaries.
Consumption, Labor, and Savings In Appendix B, I show that the value of house-
holds Ut max (14) : ct ; lt ; kh;t 0 ^ (15) satis…es a standard HJB equation, which de-
livers three optimality conditions.
8 ~t dRn ;t is constant. Intuitively, this restricts
I restrict attention to values vt that are constant if E f
‡uctuations in Tobin’s Q to be driven only by ‡uctuations in E ~t dRn ;t :

f

The …rst optimality condition is an intra-temporal condition between consumption and
labor:
1
wt = lt : (16)
ct
The second optimality condition is an asset pricing condition for deposits that can be
represented accordingly:
(it t ) dt = Et [d t= t] dt + Et [dct =ct ] V art [dct =ct ] : (17)
This condition implies that households match their expected utility return from consump-
tion to the real deposit rate, and that households are therefore indi¤erent on the margin
between consumption and deposits.
The third optimality condition is an asset pricing condition for physical capital that
can be represented accordingly:
Et [dRh;t ] (it t ) dt + Covt [d t = t ; dRh;t ] 0; (18)
with equality if kh;t > 0:

The LHS in (18) is the (expected) risk-adjusted excess return on capital over deposits
that households earn. When they earn a null risk-adjusted excess return, households are
indi¤erent on the margin between capital and deposits, and therefore they are willing to
take a capital position kh;t 0: When they earn a negative risk-adjusted excess return,
households strictly prefer on the margin deposits to capital, and therefore kh;t = 0:9 Because
they are subject to no leverage constraint, households demand compensation for holding
capital risk which is based only on consumption risk.
2.4 Competitive Equilibrium

The de…nition of the competitive equilibrium is based on the existence of a representative
…nancial intermediary, the existence of a representative household, and an indexation of
…rms that labels …rms according to the last time they had the opportunity to reset their
nominal price.10 To economize in notation, in what follows I make no distinction between
9
Households cannot earn a positive risk-adjusted excess return, because they are not subject to portfolio
constraints. If they were to obtain a positive risk-adjusted excess return, they would take unbounded
levered positions on capital, and kh;t = +1:
10
A representative …nancial intermediary exists because the leverage multiple t and marginal value of
wealth vt do not depend on individual net worth nf;t : A representative household exists because households

individual and aggregate variables. I refer to …rms that had the opportunity to reset their
nominal price for the last time at a time s t as the …rms (s; t) :
De…nition 1 A competitive equilibrium is a set of stochastic processes adapted to the

…ltration generated by Z : the real wage rate fwt g ; the real rental rate of capital services
frk;t g ; the aggregate price level fpt g ; the in‡ation rate f t g ; the real price of capital
fqt g ; the optimal nominal price fp ;t g ; the intermediate good each …rm (s; t) produces
fys;t g ; the quantity of labor each …rm (s; t) employs fls;t g ; the units of capital services
each …rm (s; t) employs fks;t g ; the …nal consumption good fyt g ; labor flt g ; the capital
position of households kh;t ; the capital position of …nancial intermediaries kf;t ; the
leverage multiple f t g ; the marginal value of wealth fvt g ; productivity fAt g ; the policy
rate fit g ; and the macro-prudential capital requirement f tg ; such that:
1. fls;t ; ks;t gs t are consistent with the labor and capital services demand functions
related to the cost function (3) ;
n o
2. fls;t ; ks;t ; ys;t gs t ; yt are consistent with production functions (1) and (4) ;
n o
3. fp ;s gs t ; pt are consistent with the consumer price index (5) ;
4. fp ;t g satis…es the optimality condition (7) in the price-setting problem of …rms;
5. f t ; vt g satisfy optimality conditions (12) and (13) in the intermediaries’ portfolio

problem;
6. yt ; lt ; kh;t satisfy optimality conditions (16) ; (17) ; and (18) in the households’
portfolio problem;
7. The labor market, the rental market for capital services, and the market for physical
capital, clear:
Z t Z t
(t s) (t s)
e ls;t ds = lt ; e ks;t ds = ah kh;t + kf;t ; and kh;t + kf;t = k :
1 1
In equilibrium, because a law of large numbers applies, the aggregate share of …rms (s; t)
equals the survival density function e (t s) of the optimal nominal price p ;s : Aggregate
are identical.

consumption ct equals aggregate output yt because there is no investment technology or
…scal policy. The market for deposits automatically clears because of Walras Law.
De…nition 1 takes monetary policy it and macro-prudential policy t as given. Mon-
etary policy sets the benchmark short-term nominal interest rate, which in equilibrium is
perfectly arbitraged with nominal deposit rate it ; because the implementation mechanism
of monetary policy is the same as in the New Keynesian framework.11
3 Equilibrium Results
I summarize the key features of the competitive equilibrium with the following three results.
The three results below shed light on the sources of ine¢ ciency in the model economy and
therefore are useful for motivating the mandates for policy.
3.1 The Leverage Multiple and Equilibrium Regions

Result 1 In equilibrium, the leverage constraint binds when …nancial intermediaries lack
enough borrowing capacity to absorb all of the aggregate capital stock. It is slack otherwise.
Let t nf;t =qt k 2 [0; 1] denote the wealth share of …nancial intermediaries. The total
wealth in the economy, i.e., nf;t + nh;t ; equals qt k because physical capital is the only
real asset. Financial intermediaries lack enough borrowing capacity to absorb all of the
aggregate capital stock when min f vt ; tg t < 1; they do have enough borrowing capacity
to absorb all of the aggregate capital stock when the opposite inequality holds.
In equilibrium, when min f vt ; tg t < 1; households hold a positive amount of physical
capital, and therefore are indi¤erent on the margin between physical capital and deposits.
Financial intermediaries strictly prefer physical capital to deposits,12 hit their leverage
constraint, and t = min f vt ; tg : When min f vt ; tg t 1; …nancial intermediaries are
indi¤erent between deposits and physical capital, and households therefore strictly prefer
deposits to physical capital on the margin. Households hold no physical capital, …nancial
intermediaries hold all of the aggregate capital stock, and t = 1= t min f vt ; tg :
11
See Clarida, Galí, and Gertler (1999) for a reference.
12
Otherwise, there would be more asset pricing conditions holding with equality than endogenous
processes to be determined in equilibrium.

3.2 The Aggregate Production Function
Result 2 The competitive equilibrium admits an aggregate production function. The
endogenous total factor productivity (TFP) in the aggregate production function deter-
mines the gap between potential and actual aggregate output as well as the phase of the
economic cycle.
In Appendix B, I show the aggregate production function is Cobb-Douglas:
yt = t lt k1 ; with t At a1t =! t :
The inputs in the aggregate production function are aggregate labor lt and the aggregate
stock of physical capital k: The labor share of output and the exogenous productivity
factor At are the same as in the individual production function of …rms. The endogenous
TFP is t =At 1: The endogenous productivity factor at is:
at ah kh;t =k + kf;t =k = ah (1 t t) + t t:
The factor a1t measures the extent to which allocative e¢ ciency problems in …nancial
markets hinder economic activity. The endogenous productivity factor 1=! t is the inverse
of the consumption-based measure of quantity dispersion on intermediate goods:
Z t Z t "
(t s) ys;t (t s) p ;s
!t e ds = e ds: (19)
1 yt 1 pt
The factor ! t measures the quantity of the …nal consumption good that could have been
produced relative to the actual quantity yt if the aggregate quantity of intermediate goods
! t yt had been evenly allocated across intermediate-goods varieties. Jensen’s inequality
implies that ! t 1; and hence that quantity dispersion across intermediate goods is
ine¢ cient. The indirect demand function yd;t (p ;s ) implies that ! t can be interpreted as
the consumption-based measure of price dispersion.
3.3 The Labor Wedge, Optimal Prices, and In‡ation Rate

Result 3 In equilibrium, a labor wedge exists if the optimal real prices p ;t =pt deviate
from the productivity factor 1=! t :

Let Bt denote the numerator on the RHS of p ;t =pt in (7) : Let Mt denote the corre-
sponding denominator. In Appendix B, I show that Bt and Mt satisfy Bt = yt = bt and
Mt = yt = mt ; with:
Z 1 "
( + )(s t) xs (yj ) pt
bt Et e ds ;
t yj ps
Z 1 "
( + )(s t) pt pt
mt Et e ds :
t ps ps
I show also that xt (yj ) =yj satis…es:
1+
xt (yj ) lt 1
= ;
yj l !t
1
with (l =lt )1+ being a labor wedge, and l ( = ) 1+ being the equilibrium quantity of
aggregate labor in the ‡exible price economy in which 1= ! 0:13
The Labor Wedge A labor wedge may exist only in the sticky price economy in which
1= 6! 0: In the ‡exible price economy, no labor wedge can exist because prices are ‡exible
as well as competitive. In the sticky price economy, a labor wedge exists only if p ;t =pt
deviates from 1=! t :14 Intuitively, starting from a situation in which there is no labor wedge
and lt = l ; if p ;t =pt deviates from 1=! t ; then in intermediate goods markets real prices de-
viate from marginal production costs, generating distortions in the quantities demanded of
intermediate goods and of inputs. These distortions, in turn, create wedges between input
prices wt and rk;t and their respective marginal productivities yt =lt and (1 ) yt =at k
which, in equilibrium, lead to deviations of lt from l in accord with:
1+ 1+
lt yt lt yt
wt = and rk;t = (1 ) :
l lt l at k
The Optimal Prices But why in equilibrium may p ;t =pt = bt =mt deviate from 1=! t ?
The reason is that the cost-revenue ratio bt =mt is forward-looking and depends on
fls =l ; 1=! s ; s gs>t : The cost-revenue ratio depends on future expected in‡ation because
13
The labor wedge is the ratio of the marginal product of labor yt =lt to the households’marginal rate
of substitution of labor for consumption lt yt :
14
See Appendix B for a formal proof.

Rs
f s gs>t
a¤ects the real price pt =ps = exp t s~d~
s and the indirect quantity demanded
" Rs
share (pt =ps ) = exp " t s~d~ s related to the …xed nominal price pt : For instance, posi-
tive future expected in‡ation rates depress the real value of …xed nominal prices pt =ps ; and
"
hence boost the corresponding indirect quantity demanded share (pt =ps ) above 1: Nega-
tive future expected in‡ation rates do the opposite. Given fls =l ; 1=! s gs>t ; ‡uctuations in
positive in‡ation rates s > 0 generate larger responses on bt =mt than equivalent ‡uctua-
tions in their negative counterparts s < 0: Intuitively, this is because inputs prices are
‡exible in nominal terms (and therefore adjust one-to-one to spot in‡ation), whereas inter-
mediate goods prices are rigid in nominal terms (and therefore do not adjust to in‡ation
at all).
The In‡ation Rate But why in equilibrium is in‡ation locally risk-free? And why does
Rs
pt =ps = exp t s~d~
s necessarily hold? The reason is that the aggregate price level pt
is time-di¤erentiable:
Z t
1
1 "
(t s) 1 "
pt = e p ;s ds :
1
Intuitively, in equilibrium, actual in‡ation dpt =pt equals expected in‡ation Et [dpt =pt ]
t dt; because …rms that can reset their nominal price during the time interval [t; t + dt]
set the same nominal price. All of these …rms set the same nominal price p ;t because the
Brownian shock dZt is a cumulative shock that fully realizes just before time t + dt arrives.
A locally risk-free in‡ation rate is consistent, in particular, with a sluggish response of
the aggregate price level pt to the shock dZt which, indeed, is the formal notion of price
stickiness in the model economy.
The expression for expected in‡ation rate t is:
" #
(" 1)
p ;t
t = 1 : (20)
" 1 pt
4 Policy Mandates and Markov Equilibrium

4.1 Policy Mandates
To study coordination between monetary policy and macro-prudential policy, I specify
two policy mandates, which I refer to as the traditional mandate and the coordinated
mandate. The policy mandates I specify are grounded in the sources of ine¢ ciency of the

model economy.
Decomposition of Utility Losses Speci…cally, policy mandates are based on the fol-
lowing partition of the utility ‡ows of households:
1 lt1+
ln + ln lt + (1 ) ln at + ln At + (1 ) ln k : (21)
!t 1+
The …rst term in (21) accounts for the utility losses from price dispersion, the di¤erence
between the second and third terms accounts for the utility losses from the labor wedge,
and the fourth term accounts for the utility losses from …nancial disintermediation. The
last two terms in (21) are exogenous and therefore uninteresting.
Traditional and Coordinated Mandate Under the traditional mandate, monetary

policy and macro-prudential policy have separate objectives and interact strategically while
taking each other’s policy rules as given. The objective of monetary policy is to maximize
the present discounted value of the …rst three terms in (21) : The objective of macro-
prudential policy is to maximize the present discounted value of the corresponding fourth
term. Under the coordinated mandate, monetary policy and macro-prudential policy are
set together and share a joint objective, which consists of maximizing the present discounted
value of the utility ‡ows in (21) : Later in the paper, I show that the individual objectives
under the traditional mandate are consistent with the traditional objective of monetary
policy of in‡ation and employment gap stability and with the traditional objective of
macro-prudential policy of …nancial stability (Smets 2014 and Svensson 2016).
4.2 The Markov Competitive Equilibrium

For simplicity, I conduct the policy analysis only in the context of a Markov competitive
equilibrium.
De…nition 2 A Markov competitive equilibrium is a set of state variables and a set of

mappings x : ! c such that (i) mappings x : ! c are consistent with the conditions
of the competitive equilibrium, and (ii) endogenous state variables in evolve in accord
with the conditions of the competitive equilibrium.

State Variables I conjecture that the set of state variables is = fA; !; g : This con-
jecture requires i and to depend only on fA; !; g :
Further Restrictions on Policy Rules To simplify the analysis, I restrict i and

to not depend on A: This restriction, together with the law of motion dAt =At ; implies
that the Markov equilibrium is scale invariant with respect to A: I also restrict to be
strictly decreasing in : This additional restriction ensures that …nancial intermediaries
are …nancially constrained, i.e., = min f v; g ; when the intermediary wealth share
is su¢ ciently low.15 Lastly, I restrict monetary policy and macro-prudential policy
to have commitment and to be designed just before the economy unravels. These last
two restrictions imply that policy uses the unconditional invariant distribution G (!; )
over aggregate states (!; ) to compute present discounted values. Intuitively, dG (!; )
indicates the share of time the economy spends in states (!; ) on average.
5 Traditional Mandate
Under the traditional mandate, monetary policy and macro-prudential policy interact
strategically in accord with a static game. The outcome of their strategic interaction
is consistent with the Nash equilibrium.
5.1 Monetary Policy

Problem Monetary policy minimizes the unconditional present discounted value of util-
ity losses from price dispersion and the labor wedge, subject to the conditions of the Markov
competitive equilibrium and the behavior of macro-prudential policy. Speci…cally:
Z
max ^ (!; ) dG (!; )
U (22)
i
subject to the conditions in De…nition 2 ;
taking as given :
15
Tobin’s Q v is also strictly decreasing in ; because dividend returns rk ; and therefore expected risk-
adjusted excess returns E~ dRn j!; ; are strictly increasing in aggregate supply of capital services to …rms
f
ak:

^ (!; ) is the present discounted value of the …rst three terms in (21) condi-
The function U
tional on states (!; ) : It solves the HJB equation:
l1+ ^ ^ 1 @2U^
^ = ln 1 +
U ln l +
@U
!! +
@U
+ ( )2 ; (23)
! 1+ @! @ 2 (@ )2
with ! being the di¤usion process of price dispersion, and and the drift and the
di¤usion processes of the wealth share : The drift process ! depends on the optimal price
p =p and on in‡ation according to:
" #
"
p 1
! = 1 +" :
p !
The di¤usion process of price dispersion ! is null because ! is time-di¤erentiable. The drift
and di¤usion processes and re‡ect the realized excess returns on internal …nancing
and on external …nancing over the total wealth in the economy that …nancial intermediaries
earn. (See Appendix B for their mathematical formula.) The invariant distribution G (!; )
is endogenously determined by the joint evolution of ! and in accord with a Kolmogorov
forward equation.
Solution I solve for the optimal monetary policy analytically. Under the traditional
mandate, monetary policy has a dominant strategy which consists of mimicking the natural
rate with policy rate i: The natural rate r~ is the real interest rate in the ‡exible price
economy:
r~dt dt + E [d~
y =~
yj ] V ar [d~
y =~
yj ] ;
with y~ a1
A~ l k1 being the aggregate output level in the ‡exible price economy, and
~1
a the endogenous TFP also in the ‡exible price economy. In the ‡exible price economy,
there is no price dispersion because all of the …rms can reset their nominal price at every
instant. Therefore, ! = 1:
Mimicking the natural rate is a dominant strategy for monetary policy, because i = r~
implements the e¢ cient mappings:
l=l and = 1 !" 1

;
" 1
independent of macro-prudential policy : The e¢ cient in‡ation rate maximizes the

rate at which price dispersion decays:
arg min ! = min ! :
The e¢ cient in‡ation rate is such that the appreciation in the aggregate price level fully
re‡ects the productivity gains from reducing quantity dispersion across intermediate goods.
The e¢ cient in‡ation rate requires that …rms set nominal prices according to p =p = 1=!:
Over the e¢ cient in‡ation rate, the aggregate price level and price dispersion evolve in
tandem, and therefore dp=p = d!=!: Price dispersion converges uniformly to ! = 1; and
there is neither price dispersion nor in‡ation at the invariant distribution.
Mimicking the natural rate implements the e¢ cient mappings l = l and = ; be-
cause those mappings, along with i = r~; are consistent with the conditions of the Markov
competitive equilibrium. Speci…cally, …rms break even when they price at 1=! — and there-
fore are willing to set prices according to p =p = 1=! — because marginal production costs
equal 1=!; and because average costs and the real value of …xed nominal prices appreciate in
tandem at the same rate of : Households are willing to consume according to c = y~=!
(and to supply labor according to l = l ) because the real interest rate is r~dt d!=!:
Along with …nancial intermediaries they are willing to take portfolio positions consistent
with a = a
~ (i.e., the endogenous TPF process of the ‡exible price economy) because risk-
adjusted excess returns remain the same as in the ‡exible price economy. Excess returns
dRe (i ) dt remain the same because in‡ation = ! o¤sets with the ‡uctuations in
q = q~=! corresponding to ‡uctuations in 1=!: Compensations for holding capital risk also
remain the same but because ! = 0; which ensures that ! does not add more aggregate
risk into the economy.
Mimicking the natural rate can implement e¢ cient mappings l = l and = in-
dependent of because there is no binding zero-lower-bound (ZLB) constraint on the
nominal rate. A slack ZLB constraint allows monetary policy to always mimic the natural
rate with the policy rate.
Discussion of Commitment Assumption Monetary policy does not require com-

mitment under the traditional mandate. The reason is that e¢ cient mappings l = l
and = ^ is such that
also maximize the RHS in the HJB (23) : Notice that value U
^ =@! < 0 and @ U
@U ^ =@ = 0:

5.2 Macro-prudential Policy
Problem Macro-prudential policy faces the same problem it would face in a ‡exible price
economy, in which monetary policy has no real e¤ects. The reason is that at the invariant
distribution, the sticky price economy behaves like the ‡exible price economy if i = r~:
Macro-prudential policy solves the same problem as (22) ; but with a control variable
of ; with an objective function of:
Z 1
(1 ) ~ (1; ) dG (1; ) ;
U
0
~
and with the behavioral constraint for monetary policy of i = r~: The value function U
satis…es the HJB equation:
~ 1 @2U~
~ = ln a + @ U
U + ( )2 :
@ 2 (@ )2
R1
I set ! = 1 in the problem of macro-prudential policy, because 0 dG (1; ) = 1:
Solution Let e denote the solution to the problem of macro-prudential policy. The
macro-prudential capital requirement e is equivalent to the constrained e¢ cient capital
requirement of the ‡exible price economy. The best response of macro-prudential policy to
mimicking the natural rate is to replicate e:
5.2.1 Macro-prudential Policy in the Flexible Price Economy
In what follows, I restrict the analysis to the ‡exible price economy. I solve for e numer-
ically using spectral methods. See Appendix C for a description of the numerical solution
method. I restrict the functional form of to a polynomial function of state : This is done
for simplicity.16 This restriction captures the notion that in general, capital requirements
cannot be freely adjusted in response to ‡uctuations in the aggregate state.
Figures 1 and 2 contrast the Markov competitive equilibria corresponding to the macro-
prudential policies = e and = L with L > min f v; 1= g : The second macro-
prudential policy does not restrict leverage, and can therefore be interpreted as a laissez-
faire policy.
16
See Appendix C for further details on the set of admissible capital requirements.

Contrast of State Functions The constrained-e¢ cient macro-prudential policy =
e restricts below its natural upper bound of min f v; 1= g occasionally, only when
…nancial intermediaries on aggregate are average capitalized, and attains intermediate
values (Figure 1a).17 The relative bene…ts of = e over = L come from three di¤erent
sources.
(a) Leverage Multiple (b) Endogenous TFP
1
3.5
0.95
0.9
3
0.85
Laissez-faire
2.5 0.8
Constrained Efficient
0.1 0.2 0.3 0.4 0.1 0.2 0.3 0.4
(c) Tobin"s Q (d) Price of Capital

1.5 0.82
0.8
1.4
0.78
1.3
0.76
1.2 0.74
0.1 0.2 0.3 0.4 0.1 0.2 0.3 0.4
Figure 1: Laissez-Faire vs. Constrained-efficient Macro-prudential

Policies in the Flexible Price Economy: State Functions
First, = e ‡attens the slope of the price of capital q with respect to wealth share
in Figure 1d when attains intermediate values. The slope of q gets ‡attened in that
intermediate region, because a binding capital requirement keeps households as marginal
investors, and therefore eliminates the large swings in q associated with changes in the
identity of the marginal investor between households and …nancial intermediaries.18 A
lower sensitivity of q with respect to reduces a distributive pecuniary externality19 that
17
When …nancial intermediaries are poorly capitalized, and is low, the leverage multiple hits its IC
borrowing limit, i.e., = v < min f e ; 1= g : When …nancial intermediaries are richly capitalized, and
is high, the leverage multiple hits its e¢ cient quantity, i.e., = 1= < min f e ; vg :
18
From the analysis in Result 1 follows that in equilibrium …nancial intermediaries have a higher valuation
for physical capital in comparison to households.
19
Distributive pecuniary externalities arise when marginal rates of substitution (MRS) between
times/states di¤er across agents and agents do not internalize the e¤ect of their individual decisions on
the others’MRS or on the relative prices at which agents in general trade (Dávila and Korinek 2017).

operates through dq=q; and that takes place because …nancial intermediaries take dq=q and
dRf as given in their portfolio problem (10) ; and because the IC borrowing capacity v
occasionally binds in the laissez-faire economy. Reducing the aforementioned distributive
pecuniary externality helps to keep the ‡uctuations in a in check. Put it di¤erently, in the
laissez-faire economy, the distributive pecuniary externality and the ‡uctuations in a are
large relative to the constrained-e¢ cient allocation, because individual …nancial intermedi-
aries do not internalize the e¤ect of their leverage decisions on the identity of the marginal
investor, on the capital gain/loss rate dq=q; and on the others’ net worth gain/loss rate
dnf =nf :
Second, = e boosts dividend yields rk =q and Tobin’s Q. Dividend yields rk =q
increase mainly because the price of capital q falls along the entire state space (Figure
1d). The price of capital falls when attains intermediate values because a binding capital
requirement extends the region in which households are the marginal investors. The price
of capital falls also in the other regions of the state space, but because q is forward-looking
and takes into account also the identity of the marginal investor in the future. Tobin’s
Q and the IC borrowing capacity v increase (Figure 1c), as a result of the increase in
~ dRn j : The positive e¤ect on v helps to boost a binding-constraint
rk =q; dRf and E f
pecuniary externality20 that operates through v; and that takes place because the value v is
endogenous and positively a¤ects the borrowing capacity min f v; g : In the laissez-faire
economy, the binding-constraint pecuniary externality is small relative to the constrained-
e¢ cient allocation, because individual …nancial intermediaries do not internalize the e¤ect
of their leverage decisions on the others’pro…tability and Tobin’s Q.
Third, and related to the second bene…t, = e redistributes the leverage multiple
progressively across the wealth share : Speci…cally, the leverage multiple increases when
is low and e is slack; it decreases when attains intermediate values and e binds
(Figure 1a) — the leverage multiple remains the same as in the laissez-faire economy when
is high because = 1= : Progressive redistributions of leverage across are bene…cial,
because the endogenous TFP is strictly increasing in ; and because the preferences for
consumption are strictly concave. Furthemore, they help to improve the dynamics of the
allocative e¢ ciency and a dynamic pecuniary externality that, in the laissez-faire economy,
…nancial intermediaries neglect.
20
Binding-constraint pecuniary externalities arise when …nancial constraints depend on endogenous vari-
ables, and agents neglect the e¤ect of their individual decisions on the variables upon which …nancial
constraints depend (Dávila and Korinek 2017).

Policy = e nonetheless also generates some costs relative to = L: Speci…cally,
= e places endogenous TFP below its potential level when binds (Figure 1b). These
costs, together with the strict concavity the preferences for consumption, imply that re-
stricting intermediary leverage below min f v; 1= g when is low is not constrained e¢ -
cient. They also imply that only moderate restrictions on when attains intermediate
values are constrained e¢ cient.
Contrast of Invariant Distributions The constrained e¢ cient macro-prudential pol-

icy not only a¤ects the Markov equilibrium state-by-state, but also at the invariant dis-
tribution (Figures 2c and 2d). In Appendix B, I show that the invariant density function
dG (1; ) satis…es:
( Z ) Z 1
1 ~~
dG (1; ) / exp 2 d~ ; with dG (1; ) d = 1:
( )2 0 ( ~ ~)2 0
A larger intermediary pro…tability and expected recovery rate implies that the
economy spends more time in states in which …nancial intermediaries are better capitalized.
It therefore helps to shift dG (1; ) rightward in the domain (Figure 2c). A lower volatility
when attains intermediate values implies that the economy spends more time in states
in which …nancial intermediaries are average capitalized. It therefore helps to shift dG (1; )
upward in that same region. The downward shift in the invariant cumulative probability
function of endogenous TFP veri…es that e improves social welfare relative to L at the
invariant distribution (Figure 2d). The e¤ects of e on the invariant distribution help to
improve the dynamic pecuniary externality and the dynamics of the allocative e¢ ciency.

(a) Drift Process (b) Diffusion Process
0.01 0.04
0 0.03
-0.01 0.02
Laissez-faire
-0.02 Constrained Efficient
0.01
0.1 0.2 0.3 0.4 0.1 0.2 0.3 0.4

Invariant Distributions
(c) Intermediary W ealth Share (d) Endogenous TFP
10 1
Prob. Density Function
Cum. Density Function
5 0.5
0 0
0.1 0.2 0.3 0.4 0.75 0.8 0.85 0.9 0.95 1
Figure 2: Laissez-Faire vs. Constrained-efficient Macro-prudential

Policies in the Flexible Price Economy: Dynamics
Discussion of Commitment Assumption In the traditional mandate, macro-prudential

policy does require commitment. Intuitively, the reason is that the costs from = e ma-
terialize on impact, while its bene…ts materialize in the medium and long terms. The …rst
bene…t materializes mainly around the region in which e binds. The second and the
third materialize only when wealth share is low and e is slack. Commitment is indeed
critical for the second and third bene…ts to materialize: If macro-prudential policy were to
not have commitment, …nancial intermediaries and households would not believe that e
would restrict intermediary leverage eventually when recovers and, as a consequence, the
price of capital would not fall when is low.
6 Coordinated Mandate
Under the coordinated mandate, monetary policy and macro-prudential policy together
maximize social welfare subject to the conditions of the Markov competitive equilibrium.

Problem Monetary policy and macro-prudential policy face the same problem as (22) ;
but with control variables i and ; and an objective function of:
Z h i
U^ (!; ) + (1 ~ (!; ) dG (!; ) :
)U
I make a change of variable in the optimization problem above to simplify the analysis.
Speci…cally, I replace the policy rate i with the employment gap ln (l=l ) : This change of
variable is admissible, because in any competitive equilibrium, the policy rate can be de-
rived as a residual using the asset pricing condition for deposits. It is convenient, because
the employment gap can be interpreted as the monetary policy stance. For instance, a
positive employment gap can be interpreted as an expansionary monetary policy, while
a negative employment gap can be interpreted as a contractionary monetary policy. A
positive employment gap precisely when …nancial intermediaries on aggregate are poorly
capitalized can be interpreted as a Greenspan put, while a negative employment gap when
…nancial intermediaries are average- to richly capitalized can be interpreted as leaning
against the wind. A permanently null employment gap can be interpreted as macroeco-
nomic stabilization. All these interpretations make sense because monetary policy can
implement any employment gap independent of macro-prudential policy provided the ZLB
constraint on the policy rate is always slack.
Solution I solve for the optimal coordinated policy numerically using spectral methods.
I restrict attention to employment gaps and capital requirements that are contingent only
on wealth share : Furthermore, I restrict attention to employment gaps that are a linear
function of and capital requirements that are a polynomial function of : This is done
for simplicity.21
Figure 3 contrasts the Markov competitive equilibria between the traditional mandate
and the coordinated mandate. Under the coordinated mandate, monetary policy deviates
from its traditional objective of macroeconomic stabilization (Figure 3a). Monetary policy
deviates in accord with the prescriptions of the Greenspan put and of leaning against the
wind, but relies more heavily on the prescriptions of the latter. Macro-prudential policy
softens the capital requirement relative to the traditional mandate, though the adjustment
state-by-state is small (Figure 3b).
21
See Appendix C for further details.

10 -3 (a) Employment Gap (b) Leverage Multiple
4
2 3.5
0
3
-2
-4
T raditional Mandate
2.5
-6 Coordinated Mandate
0.1 0.2 0.3 0.4 0.1 0.2 0.3 0.4

Invariant Distributions
(c) W ealth Share of Fin. Intermediaries (d) Price Dispersion
10 1
Prob. Density Func.
Cum. Density Func.
5 0.5
0 0
0.1 0.2 0.3 0.4 1 1.0005 1.001 1.0015 1.002
Figure 3: Traditional Mandate vs. Coordinated Mandate
To explain the rationale behind the behavior of monetary policy under the coordinated
mandate, I …rst analyze three candidate monetary policies. The …rst is a non-contingent
employment gap that is constant over state : I analyze only a positive employment gap;
the analysis for a negative non-contingent employment gap is equivalent.
A positive non-contingent employment gap increases inputs prices w and rk relative
to the ‡exible economy. The reason is that real wages must increase in equilibrium to
induce households to supply more labor. Higher inputs prices boost marginal production
costs, induce …rms to target higher real prices, and generate positive in‡ation rates. In
equilibrium, in‡ation rate > 0 and price dispersion ! > 1 are constant, and in particular,
satisfy that:
" #" 1
" (1+ )
" 1 (" 1) l + "
1= + ;
l + (" 1) "
"
(" 1) " 1
!= :
"
A positive non-contingent employment gap nonetheless does not a¤ect the productivity
factor a or the utility losses (1 ) ln a from …nancial disintermediation. Those variables

remain the same as in the ‡exible price economy, because dividend yields rk =qdt; excess
returns dRe (i ) dt; and compensations for holding capital risk remain the same.
Dividend yields remain the same because the price of capital q is a present discounted value
of dividend returns, which implies that q increase in tandem with the permanent increase
in rk : Excess returns and compensations for holding capital risk also remain the same, but
because non-contingent employment gaps bring no additional risk into the economy.
The …rst candidate monetary policy delivers two takeaways. The …rst is that non-
contingent employment gaps do not help to improve on …nancial stability relative to macro-
economic stabilization. The key problem with non-contingent employment gaps is that they
generate no transitory e¤ects on dividend returns rk dt: Only transitory e¤ects prevent the
price of capital from adjusting one-to-one to changes in rk dt: The second takeaway is that
non-contingent employment gaps are actually worse in terms of social welfare than macro-
economic stabilization. Positive non-contingent employment gaps are even worse than their
negative counterparts, because of the asymmetric responses of optimal real price p =p (and
hence of price dispersion !) to in‡ation at = 0:
The second and third candidate monetary policies are a Greenspan put and leaning
against the wind. In contrast to non-contingent employment gaps, the Greenspan put and
leaning against the wind generate transitory e¤ects on rk dt: This is because they target
employment gaps that are contingent on the wealth share : The Greenspan put and leaning
against the wind generate opposite transitory e¤ects on dividend returns rk dt; but similar
transitory e¤ects on dividend yields rk =qdt and on productivity factor a:
Speci…cally, by design, the Greenspan put targets positive employment gaps when is
low, while it stabilizes the employment gap at zero when is average to high. Relative to
the ‡exible price economy, dividend returns rk dt increase when is low, while they remain
fairly constant when is average to high. Dividend yields rk =qdt also increase when
is low, but decrease when is average to high, because the price of capital is forward-
looking. The shift in dividend yields boosts the pro…tability of …nancial intermediaries,
relaxes moral hazard problems in credit markets, and speeds up the recapitalization of
…nancial intermediaries in expectation only when is low. It has the opposite e¤ects when
is average to high. The resulting progressive redistributions across of the intermediary
pro…tability and of IC borrowing capacity help to reduce the present discounted value of
(1 ) ln a:
Leaning against the wind stabilizes the employment gap at zero when is low, while
it targets negative employment gaps when is average to high. Relative to the ‡exible

price economy, dividend returns rk dt then remain fairly constant when is low, and they
decrease when is average to high. Dividend yields rk =qdt nonetheless increase when is
low and decrease when is average to high, because the price of capital falls over the entire
domain of : The shift in dividend yields is therefore similar to the shift in the Greenspan
put. Intermediary pro…tability, IC borrowing capacity, and productivity factor a; also shift
similar to the Greenspan put.
Overall, when compared to macroeconomic stabilization, the Greenspan put and leaning
against the wind always perform better in terms of …nancial stability, but worse in terms
of macroeconomic stability. Gains in …nancial stability outweigh losses in macroeconomic
stability only if deviations in the employment gap are su¢ ciently small. The reason is that
in the traditional mandate, l = l and ! = 1 are e¢ cient, but 6= 1= is not e¢ cient. For
any given absolute deviation in the employment gap, losses in macroeconomic stability are
larger for the Greenspan put than for leaning against the wind, because of the asymmetric
responses of p =p and ! to in‡ation at = 0:
In the coordinated mandate, monetary policy leverages on the takeaways provided
by the three candidate monetary policies. Speci…cally, monetary policy combines the
Greenspan put and leaning against the wind to help macro-prudential policy increase the
present discounted value of (1 ) ln a relative to the traditional mandate. Combining the
Greenspan put and leaning against the wind strengthens the temporary e¤ects on dividend
returns rk and dividend yields rk =qdt: Furthermore, it smooths utility
h losses from
i price
1 1+ 1+
dispersion ln ! and employment gap instability ln l =l + 1+ l 1 (l =l) across
:
Macro-prudential policy softens the capital requirement relative to the traditional man-
date, because the capital requirement becomes less valuable once monetary policy also re-
sponds to …nancial stability concerns. Speci…cally, the second and third bene…ts from e
become less valuable, because monetary policy also redistributes intermediary pro…tability
and e¤ective borrowing capacity min f v; g progressively across wealth share : The …rst
bene…t from e becomes less valuable as well, but because monetary policy reduces the IC
borrowing capacity v when is average to high.
Discussion of Commitment Assumption In the coordinated mandate, monetary pol-

icy and macro-prudential policy require commitment. The reason is that the costs from
leaning against the wind and from the capital requirement materialize on impact while
their bene…ts materialize in the medium and long terms. Commitment is critical for those

bene…ts to materialize in the …rst place.
7 Social Welfare Gains from Coordination

I calibrate the model economy to quantify the costs and bene…ts of the coordinated mandate
over the traditional mandate.
Calibration Table 1 reports parameter values in the baseline calibration. The time
frequency is annual.
Table 1: Parameter Values

Parameter ah A A k "
6
Value 70% 2:5 1% 10% 1:5% 3:5% 65% 1 2 5 ln 2 2% 3 2:8
The …rst three parameters in Table 1 target unconditional averages in the laissez-faire
‡exible price economy, in which there is no macro-prudential policy. The productivity
coe¢ cient of households ah targets an unconditional average Sharpe ratio of 30%; which is
standard. The value of ah is 70%: The fraction of divertable assets targets an uncondi-
tional average leverage multiple of 3:5: The value of is 2:5: The initial capital endowment
of starting …nancial intermediaries targets the unconditional average wealth-to-capital
ratio in the …nancial intermediary sector. I use a target of 20%; which is consistent with
the estimates of Hirakata, Sudo and Ueda (2013). The value of is 1%: The cycle for
intermediary dividend payouts can be interpreted as the life cycle of individual …nancial
intermediary companies (Gertler and Karadi 2011; Gertler and Kiyotaki 2010; Maggiori
2017). I set arrival rate to target an unconditional average survival frequency of 10 years,
which is consistent with Gertler and Kiyotaki (2010).
The drift and di¤usion processes A and A match the unconditional mean and tuncon-
ditional standard deviation of the Utilization-Adjusted Series on Total Factor Productivity
(see Fernald 2014). The value of A is 1:5%: The value of A is 3:5%: The labor share
of output is 65%; which is consistent with the empirical …ndings of Karabarbounis and
Nieman (2014). The aggregate stock of physical capital k is normalized to 1:
The elasticity of substitution between intermediate goods " is 2: This value is below
the regular values, ranging from 4 to 6; that are usually set in sticky price economies in

which …rms reset their nominal price sluggishly according to Calvo (1983) pricing. I set
a relatively low value for " to accommodate the recent empirical …ndings of Nakamura
and Steinsson (2017), who show that Calvo (1983) pricing over estimates social welfare
costs from price dispersion relative to those measured in data, even for low in‡ation rates.
Nakamura and Steinsson (2017) also show that the resulting over estimation critically
depends on, and is positively related to, the value of ": I use the expression for the in‡ation
rate (20) to set the value of ": The value " = 2 is consistent with an annual in‡ation
rate of 3% and with a price percentage change of p =p = 1:075; given a constant in‡ation
rate. Nakamura and Steinsson (2017) argue that the absolute size of price changes is an
acceptable proxy indicator for ine¢ cient price dispersion; they report an unconditional
average for the absolute size of price changes of 7:5% in the U.S. from 1988-2014.
The arrival rate of the Poisson process that allows …rms to reset their nominal price
6
is 5 ln 2: This value yields a median frequency of price change of 10% per month, which is
consistent with Nakamura and Steinsson (2008, 2017).
The time discount rate is 2%: The Frisch elasticity of labor supply is 0:5; which is
consistent with the empirical …ndings of Chetty, Guren, Manoli and Weber (2011). The
relative utility weight of labor matches an unconditional average share of labor hours of
1=3 per unit of time.
Quantitative Gains Table 2 reports the social welfare gains of the coordinated mandate
over the traditional mandate. Social welfare gains are computed relative to the traditional
mandate; they are expressed in terms of annual consumption equivalent.
Table 2: Social Welfare Gains from Coordination

Present Discounted Value of
l1+
ln 1=! ln l 1+ (1 ) ln a Utility Flows
Baseline Calibration 0:04% 0:00% +0:11% +0:07%
Baseline but with ah = 60% 0:05% 0:01% +0:15% +0:09%
4
Baseline but with = 5 ln 2 0:06% 0:01% +0:20% +0:13%
Baseline but with " = 4 0:05% 0:00% +0:07% +0:02%
Table 2 shows that social welfare gains amount to 0:07% in the baseline calibration.
Table 2 also shows that social welfare gains are larger if productivity gap 1 ah is larger

and/or if the frequency at which …rms can reset their nominal price is lower. Social welfare
gains are strictly increasing in 1 ah ; because the price of capital and the intermediary
wealth share ‡uctuate more if valuation di¤erences concerning risky assets are larger. They
are strictly decreasing in ; because a lower share of …rms sets a nominal price away from
the aggregate price level if nominal prices are more rigid.
8 Conclusion
In this paper I develop a tractable model economy to study coordination between monetary
policy and macro-prudential policy. I restrict attention to two speci…c policy mandates: a
traditional mandate and a coordinated mandate. Under the traditional mandate, monetary
policy mimics the natural rate, and macro-prudential policy implements the constrained-
e¢ cient capital requirement of the ‡exible price economy. Under the coordinated mandate,
monetary policy deviates from the natural rate in accord with the prescriptions of the
Greenspan put and leaning against the wind, and macro-prudential policy softens the
capital requirement relative to the traditional mandate. In the baseline calibration, social
welfare gains from coordinating monetary policy and macro-prudential policy amount to
0.07% in terms of annual consumption equivalent.
The main results in this paper are robust to the source of fundamental shocks that
hit the economy. The main mechanisms in play are robust to the microfoundations con-
cerning the price-setting behavior of …rms. The main results depend, nonetheless, on the
binding status of the ZLB constraint on the nominal interest rate. This is because if the
ZLB constraint binds (or occasionally binds), in‡ation and the employment gap do not re-
main stable at their structural levels. A detailed analysis concerning coordination between
monetary policy and macro-prudential policy when the ZLB constraint occasionally binds
remains for future research.

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Appendices
Appendix A lays out the moral hazard problem in equity markets. Appendix B derives the
analytical solution of the model economy. Appendix C describes the numerical solution
method.
Appendix A
The Moral Hazard Problem in Equity Markets
The structure of equity markets and the moral hazard problem in equity markets are such
that: (i) neither …nancial intermediaries nor households directly hold physical capital; (ii)
the direct holders of physical capital (which consists of some physical capital lessors) issue
equity shares against the present discounted value of the pro…t ‡ows made from renting
the capital services to …rms; and (iii) equity shareholders (which consists of …nancial
intermediaries or households) can monitor the activities of equity issuers, having …nancial
intermediaries a comparative advantage at monitoring relative to households. The moral
hazard problem between the physical capital lessors (hereafter capital lessors) and their
shareholders is based on the textbook moral hazard problems in Tirole (1998).
The Moral Hazard Problem Capital lessors own all of the aggregate capital
stock in the economy. By exerting costly e¤ort, capital lessors can increase in probability
the productivity rate a at which they transform physical capital into capital services.
The productivity rate a is stochastic and can be either high or low. If the rate is high,
the …rms involved in the rental transaction receive aS > 1 units of capital services per unit
of physical capital rented out. If the rate is low, the …rms receive no units of capital services
at all. Conditional on a same-e¤ort decision, productivity rates are i.i.d. across capital
lessors. For simplicity, and to ensure that the quantity of capital services that each …rm
receives is deterministic, I assume that each …rm rents physical capital from a continuum
of di¤erent capital lessors that take the same e¤ort decision. Exerting e¤ort improves the
probability of a high rate from Pn > 0 to Pe > Pn ; with Pe < 1; being Pn the probability
of a low rate conditional on not exerting e¤ort. Exerting e¤ort nonetheless entails the loss
of a positive private bene…t for capital lessors. Such private bene…t is proportional to the
stock of physical capital rented out to …rms and, for simplicity, is expressed in terms of
units of capital services.
Let > 0 denote the private bene…t of capital lessors per unit of physical capital

rented out. The net present value (NPV) condition Pe aS > Pn aS + ; together with the
private bene…t > 0; implies a moral hazard problem between capital lessors and their
shareholders.
Solution to the Moral Hazard Problem Shareholders can solve the moral haz-
ard problem by implementing one of the following two strategies. The …rst is to monitor
e¤ort decisions. Monitoring eliminates the possibility of not exerting e¤ort. When con-
ducted by …nancial intermediaries, monitoring is costless, but when conducted by house-
holds, monitoring scales down the high productivity rate by ah < 1:22 The second strategy
is to write a contract contingent on the realization of the outcome of the productivity rate,
to incentivize capital lessors to exert e¤ort. From the point of view of shareholders, who
are the agents who write the contract, the optimal incentive-compatible contract (i.e., that
incentivizes capital lessors to exert e¤ort and minimizes the expected payment to lessors)
1
promises a unitary payment of Pe Pn > 0 in terms of capital services contingent on a
high productivity rate. The optimal incentive-compatible contract cannot promise nega-
tive payments because capital lessors are protected from limited liability. The cost to the
Pe
shareholders of the optimal incentive-compatible contract is Pe Pn > 0:
Financial intermediaries prefer monitoring to the optimal incentive-compatible con-
Pe
tract, because to them monitoring is costless. I impose that Pe aS ah > Pe aS Pe Pn to
ensure that household also prefer monitoring to the optimal incentive-compatible contract.
Interpretation I normalize Pe aS to 1; and interpret Pe aS = 1 as the quantity
of capital services, per unit of physical capital, that …nancial intermediaries can rent out
to …rms in a reduced-form economy in which there are no capital lessors, and …nancial
intermediaries and households own all of the aggregate capital stock. I interpret Pe aS ah =
ah < 1 similarly, but for households.
Appendix B
Solving the Portfolio Problem of Financial Intermediaries
To solve for portfolio problem (10) ; I proceed in two steps. First, I derive the HJB equation
related to (10) : Then, I take F.O.C.s and manipulate the F.O.C.s and the HJB equation
22
For monitoring to play a role, I assume that …nancial intermediaries cannot monitor on behalf of
shareholders who are households. To that end, I assume that capital lessors can issue a single share or,
alternatively, that shareholders must monitor individual units of physical capital, to ensure that capital
lessors exert e¤ort on each unit.

accordingly to obtain optimality conditions (12) and (13) :
Let Gv;t denote the gain process:
Z 1 Z t
s s t
Gv;t Et e s nf;s ds = e s nf;s ds +e t vt nf;t :
0 0
The equality on the RHS follows from the de…nition of Vt and from the result that Vt =
vt nf;t : The drift process of Gv;t is null because Gv;t is the conditional expectation of a
random variable. Applying Ito’s Lemma to the RHS in Gv;t ; and then equalizing the
resulting drift process to zero, delivers the HJB equation:
n h i o
vt = max + ;t + v;t + nf ;t + ;t v;t + ;t nf ;t + v;t nf ;t vt (24)
t
s:t: : t min f vt ; tg ;
with x;t and x;t being the drift and di¤usion processes of the generic process xt ; with
xt = f t ; vt ; nf;t g : Processes nf ;t and nf ;t depend on leverage multiple t; in accord with
(11) : Processes ;t and ;t do not depend on t; because the SDF t depends only on
aggregate consumption. Neither do the value vt nor its drift and di¤usion processes v;t and
v;t depend on t; because the value Vt = vt nf;t is the value function of the optimization
problem in (10) :
The optimality condition (12) follows from the F.O.C. in the optimization problem on
the RHS in (24) : The optimality condition (13) follows from evaluating (12) in (24) and
from subsequently manipulating the resulting expression accordingly.
Solving the Portfolio Problem of Households

To solve for the portfolio problem max (14) : ct ; lt ; kh;t 0 ^ (15) ; I proceed in two steps
as before.
First, I conjecture that the value of households Ut satis…es:
Ut = U (nh;t ; Jt ) ;
with U : R2 ! R being a twice continuously di¤erentiable function, and Jt a su¢ cient

statistic of the aggregate state variables in the households’ problem. The process Jt is
a scalar. I further conjecture that Jt follows an Ito process with drift process J;t and
di¤usion process J;t :

The value Ut is the solution to the HJB equation:
8 9
> lt1+ @Ut @Ut >
>
> ln ct + nh ;t nh;t + J;t Jt + >
>
< 1+ @nh;t @Jt =
Ut = max ;
ct ;lt ;kh;t 0 >
> 1 @ 2 Ut @ 2 Ut 1 @ 2 Ut
>
>
>
: ( 2
nh ;t nh;t ) + J;t Jt nh ;t nh;t + ( J;t Jt )
2 >
;
2 (@n )2 @Jt @nh;t 2 (@Jt )2
h;t
(25)
with nh ;t and nh ;t being the drift and di¤usion processes of nh;t : Processes nh ;t and nh ;t
depend on the controls ct ; lt ; kh;t ; in accord with (15) : Neither process Jt nor its drift and
di¤usion processes J;t and J;t depend on individual controls ct ; lt ; kh;t :
Second, I take F.O.C.s. to derive optimality conditions (16) ; (17) and (18) : The …rst-
order condition with respect to consumption ct is:
1 @Ut
= :
ct @nh;t
The …rst-order condition with respect to labor lt is:
@Ut
lt = wt :
@nh;t
The …rst-order condition with respect to physical capital kh;t is:
rk;t @Ut @ 2 Ut @ 2 Ut
nh ;t + q;t (it t) + q;t nh ;t nh;t + q;t J;t Jt 0:
qt @nh;t (@nh;t )2 @Jt @nh;t
with equality if kh;t > 0:

Optimality condition (16) follows from combining the …rst two …rst-order conditions.
The optimality conditions (17) and (18) follow from applying the same methodology as
in Cox, Ingersoll and Ross (1985). Speci…cally, …rst, replace the …rst-order conditions in
the HJB equation above; second, take the …rst-order condition with respect to nh;t in the
expression obtained in the …rst step; and third, re arrange the expression obtained in the
second step accordingly.
Competitive Equilibrium: Proofs

Aggregate Production Function
Here, I show that the aggregate production function is yt = t lt k1 ; with t At a1t =! t :

The inputs demand functions of …rms, i.e., ld;t (yj;t ) ; kd;t (yj;t ) ; are consistent with the
cost function in (3) ; and therefore are:
1
1 rk;t
ld;t (yj;t ) = yj;t ;
At 1 wt
1 1 wt
kd;t (yj;t ) = yj;t :
At rk;t
The function yt = t lt k1 follows from replacing fls;t ; ks;t g with fld;t (yj;s ) ; kd;t (yj;s )g in
the market clearing conditions for inputs and from subsequently manipulating the resulting
expressions accordingly. Speci…cally, the aforementioned replacement delivers:
1
1 rk;t
! t yt = lt ;
At 1 wt
1 1 wt
! t yt = ah kh;t + kf;t ;
At rk;t
which, in turn, delivers:

rk;t lt lt
= =
1 wt ah kh;t + kf;t at k
Evaluating this last expression in any of the two expression above delivers the aggregate
production function.
Labor Wedge
Here, I derive the processes fbt ; mt g ; the aggregate quantity of labor in the ‡exible price
economy l ; and the labor wedge.
The processes bt and mt follow from evaluating the SDF =e t =y in Bt and Mt :

t t
1
The quantity l follows from evaluating conditions rk;t at k = wt lt and wt = lt yt
in the cost function xt (yj ) =yj and from subsequently solving for the quantity of lt that
satis…es xt (yj ) =yj = 1: In the ‡exible price economy, p ;t =pt = 1 — and hence p ;t =pt =
xt (yj ) =yj = 1 — because all of the …rms can reset their nominal price at every instant.
The labor wedge follows from manipulating the expression wt = lt yt accordingly to re-
write wt as the product of yt =lt and a residual. The obtained residual is the inverse of
the labor wedge.

Labor Wedge and Optimal Real Prices
Here, I show that lt =l 6= 1 only if p ;t =pt deviates from 1=! t : To do so, I proceed in steps.
Let t > 0 be such that p ;t =pt = t =! t : First, I express the law of motion (LoM) of
price dispersion and the expected in‡ation rate as function of t:
Price dispersion ! t evolves according to:23
"" # #
"
d! t p ;t 1
= 1 +" t dt; (26)
!t pt !t
being the expected in‡ation rate t given by:

" #
(" 1)
p ;t
t = 1 : (27)
" 1 pt
Evaluating p ;t =pt = t =! t and (27) in (26) delivers:

" #
(" 1)
d! t t 1
= 1 " (" 1) t dt (28)
!t " 1 !t
The expected in‡ation rate satis…es:

" #
(" 1)
t
t = 1 :
" 1 !t
Notice that d! t =! t !;t dt = t dt if and only if t = 1:

+
Let < 1+ " : Second, I show that t = is consistent with lt =l = l =l ; being l
given by:
1
+ " ( 1) 1+
l =l :
+ (" 1) ( 1)
23
I show this in Section 5. To obtain the law of motion for price dispersion, take the derivative with
respect to time in expression (19) : To obtain the LoM of price dispersion, take the derivative with respect
to time in expression (19) : In Section 3, when I analyze the properties of the aggregate price level and
in‡ation, I derive the formula for the expected in‡ation rate t :

Optimality condition (7) implies that p ;t =pt = =! t = bt =mt ; with
Z 1 1+ Z s
1 ( + )(s t) ls
bt = Et e exp " s~ !;~
s d~
s ds ;
!t t l t
Z 1 Z s
( + )(s t)
mt = Et e exp (" 1) s~d~
s ds :
t t
If lt =l is constant, then it has to equal:

" R1 Rs # 1
Et t e ( + )(s t) exp (" 1) s~d~
s ds 1+
lt =l = R1 R st :
Et t e ( + )(s t) exp
t " s~ s d~
!;~ s ds
Under a constant t = ; (28) is a Bernoulli di¤erential equation with constant functions

Pt = P and Qt = Q; whose solution is:
h i 1
(" 1) (" 1) (s t) (" 1) " 1
!s = !t ! e +! ;
1
1
being ! " (" 1) " 1
the steady state level of price dispersion, which is
unique and stable. If price dispersion is in steady state, and ! t = ! ; then !;t = 0 and
t = ( 1) ; and the RHS on lt =l is:
1
+ " ( 1) 1+
l =l = :
+ (" 1) ( 1)
+
For the integrals on the RHS on lt =l to be well-de…ned, 1< " has to hold.
Third, and lastly, I show that lt =l 6= 1 only if t 6= 1: To such end, I restrict t to be
constant if and only if lt =l is constant. Intuitively, because in equilibrium a constant lt =l
is consistent with a constant t and ! t ; this restriction implies that ‡uctuations in optimal
real prices o¤ ‡uctuations in the productivity factor 1=! t correspond to ‡uctuations in the
labor wedge. The analysis conducted in the …rst and second steps of this proof, coupled
with the aforementioned restriction on t; ensures that lt =l = 1 if t = 1 and that lt =l 6= 1
if t 6= 1:
Asset Pricing Conditions
The asset pricing conditions are useful for characterizing the Markov equilibrium.

The asset pricing conditions for deposits is:
2
it t = + y;t y;t :
The asset pricing condition for physical capital depends on whether …nancial intermedi-
aries are …nancially constrained. When …nancial intermediaries are …nancially constrained,
the asset pricing condition is (18) holding with equality. When they are …nancially uncon-
strained, the asset pricing condition is instead (12) holding also with equality. I conjecture
that the price of capital qt is proportional to aggregate output yt : Let q^t = qt =yt denote the
price of capital per unit of aggregate output. In equilibrium, the asset pricing condition
for physical capital is:
1+
ah 1 lt
+ q^;t =0;
q^t at k l
with t = min f vt ; tg if …nancial intermediaries are …nancially constrained; the asset
pricing condition for physical capital is
1+
11 lt
+ q^;t + v;t ( q^;t + y;t ) =0;
q^t k l
with t = 1= t < min f vt ; tg if …nancial intermediaries are …nancially unconstrained.24

The asset pricing condition for Tobin’s Q is:
" #
1+
1 ah 1 lt
+ v;t ( q^;t + y;t ) t1 t <1= t
+ + v;t y;t v;t =0:
q^t at k l vt
1 ~
Notice that dt Et
dRnf ;t equals the …rst term on the LHS when …nancial intermediaries
~t dRn ;t = 0 when …nancial intermediaries
are …nancially constrained. Notice also that E f
are …nancially unconstrained.
Markov Competitive Equilibrium

Characterization of the Markov Equilibrium
The mappings that characterize the Markov equilibrium are f^

q ; v; ; l; g : I restrict atten-
tion to Markov equilibria in which ln l=l and are contingent only on : I conjecture that
24
The conjecture qt = q^t yt implies that q;t = q^;t + y;t + q^;t y;t and that q;t = q^;t + y;t : Notice
that at = 1 when t = 1= t :

q^ and v depend only on :
Conditions that Characterize the Markov Equilibrium

The Markov equilibrium is characterized by the conditions a = ah (1 )+ ; =
min f v; ; 1= g ; (29)-(40) : In what follows, I derive conditions (29)-(40) :
Law of Motion Revisited

The in‡ation equation (20) implies that ! is:
" " #
1 " 1 " 1
! = 1 1 +" (29)
!
Let "x; denote the elasticity of a given mapping x with respect to state : Let x denote
the partial derivative of mapping x with respect to state : Ito’s Lemma implies that the
drift and the di¤usion processes x and x satisfy that:
1 2
x = "x; + "x ; "x;
2
x = "x; ;
The di¤usion processes q^ and y satisfy, in particular, that:
q^ = "q^;
y = A + "l; + (1 ) "a; :
From = q ( 1) ; it follows that satis…es that:
1
= A; (30)
1 ["q^; + "l; + (1 ) "a; ] ( 1)
and that satis…es that:

" #
1+
1 11 l 1 2
= + ( 1) "q^ ; 1 "q^; ( 1) :
1 "q^; ( 1) q^ ak l 2
(31)

Asset Pricing Conditions Revisited
The asset pricing condition for physical capital is:
1+
ah 1 l 1 2
+ "q^; + "q^ ; "q^; = 0; if = min f v; g ; (32)
q^ ak l 2
1+
11 l 1 2
+ "q^; + "q^ ; "q^; + v ( q^ + y) = 0; if = 1= < min f v;(33)
g
q^ k l 2
The asset pricing condition for Tobin’s Q is:

" #
1+
1 ah 1 l 1 2
+ v ( q^ + y) 1 <1= + + "v; + "v ; "v; y v =0
q^ ak l v 2
(34)
Notice in particular that:
v = "v; (35)
q^ = "q^; (36)
1
y = A q^ (37)
1 ["q^; + "l; + (1 ) "a; ] ( 1)
ODEs
Asset pricing conditions (32)-(37) deliver an ordinary di¤erential equation system (ODEs)
of second order. The independent variable in the ODEs is : The dependent variables are q^
and v:25 The boundary conditions for the ODEs are similar to those in the autarky banking
economy of Maggiori (2017). Speci…cally, I impose that:
d
lim q^ + y = 1 and lim ( q^ + y) = 0; (38)
!1 !1 d
and that:
d
lim v = 0 and lim v = 0: (39)
!1 !1 d
25
The quantity of aggregate labor l and capital requirement are taken as given in the Markov equilib-
rium. Notice that a = ah (1 )+ and that = min f v; ; 1= g :

Intuitively, boundary conditions (38) and (39) imply that endogenous risk vanishes smoothly
as …nancial intermediaries own all of the wealth in the economy.
Consistency Condition for In‡ation

The in‡ation rate is the solution to the equation:
R1 nR h " i o 1+
1 s 1 " 1 ls
!E exp t ! s~ 1 d~
s dsj!;
1 " 1
t s~ l
" 1 " 1
1 = R1 Rs
E t exp t [(" 1) s~ ( + )] d~
s dsj!;
(40)
The LHS equals p =p: The numerator on the RHS is expected production costs b; the
denominator is expected sales revenues m: In this notation, s = (! s ; s) and ls =
l (! s ; s) :
Invariant Distributions and Kolmogorov Forward Equations
The invariant density function dG (!; ) solves the Kolmogorov forward equation:
@ @ @2 h i
[ ! !dG (!; )] dG (!; ) + ( )2 dG (!; ) = 0:
@! @ @ 2
In the ‡exible price economy, the invariant density function dG (1; ) solves:
@ @2 h i
dG (1; ) + ( )2 dG (1; ) = 0;
@ @ 2
which implies that dG (1; ) satis…es:

( Z )
1 ~~
dG (1; ) / exp 2 2 d~
( )2 0 ( ~ ~)
R1
with 0 dG (1; ) d = 1:
Appendix C
The Numerical Method
The numerical method has two steps. The …rst is similar for both policy mandates, but
the second di¤ers.

The …rst step solves the ODEs taking policy rules fln l=l ; g as given. To solve for
the ODEs, I use spectral methods. Speci…cally, I interpolate mappings q^ and v with linear
combinations of Chebyshev Polynomials of the First Kind. I evaluate the interpolation at
the Chebyshev nodes using a grid with 190 points. I use a nonlinear solver to …nd the
coe¢ cients associated with the Chebyshev Polynomials in the linear combination. I use as
my initial guess the Markov equilibrium in the frictionless economy. That is, l = l ; =
1= ; q=rk = 1= ; v = 1; ! = 1: In the traditional mandate l = l always, whereas in the
coordinated mandate l = l is not necessarily the case.
The second step proceeds di¤erently, depending on the policy mandate. In the tradi-
tional mandate, the second step derives the constrained e¢ cient capital requirement e:
To this end, …rst, I compute the invariant density function dG (1; ) using drift and the
di¤usion processes and : Second, I compute the present discounted value of ln a which
indicates also the indirect utility value associated with : I repeat the …rst and second steps
for di¤erent capital requirements until I …nd the capital requirement e that achieves the
maximum possible indirect utility value. Below, I specify the capital requirements among
which I searched.
In the coordinated mandate, the second step derives the policy rules that maximize
social welfare. To this end, …rst, I derive the rate that satis…es the consistency condition
for in‡ation, given the policy rules fln l=l ; g and the solution to the ODEs. Below, I
explain the process I follow to solve for the consistency condition for in‡ation. Second, I
use to derive drift process !; and then use !; together with drift and di¤usion processes
and ; to simulate the invariant density function dG (!; ) : With the invariant density
function dG (!; ) ; I compute social welfare and the indirect utility value associated with
fln l=l ; g : I repeat the …rst and second steps for di¤erent policy rules until I …nd the
policy rules that maximize social welfare. Below, I also specify the policy rules among
which I searched.
Restrictions on Policy Rules
I impose a polynomial functional form for the capital requirement. Speci…cally:
D
X ad d
( )= d
( 1) :
d=0
( 2 1)

The constants 1 and 2 are the values of such that intersects with v and 1= ;
respectively. The constant 2 is always greater than 1: The natural number D denotes
the degree of the polynomial. The real constants fad g are such that: (i) and its …rst
1
2 (D 1) derivatives match v and its corresponding derivatives at = 1; and (ii) and
1
its …rst 2 (D 1) derivatives match 1= and its corresponding derivatives at = 2: The
natural number D is always odd. The restriction on the real constants fad g is imposed to
reduce the dimensionality of the search problem. Notice that the constants 1 and 2 are
the only free parameters in ( ) independent of the value of D: In the numerical solution,
a value of D beyond 7 does not improve social welfare.
I impose a linear functional form for the employment gap. Speci…cally:
ln [l ( ) =l ] = al ( l) :
The constant al is the semi-elasticity of aggregate labor with respect to : The constant l
indicates the state at which the sign of the employment gap switches.
Consistency Condition for In‡ation
I characterize mt and bt as the solution to a system of partial di¤erential equations (PDEs).
Asset Pricing Conditions

The expected marginal sales revenues mt satis…es that:
Z 1 Z s
mt = Et exp [(" 1) s~ ( + )] d~
s ds :
t t
Let Gm;t denote the gain process:

Z 1 Z s
Gm;t Et exp [(" 1) s~ ( + )] d~
s ds
0 0
Z t Z s Z t
= exp [(" 1) s~ ( + )] d~
s ds + exp [(" 1) s~ ( + )] d~
s mt :
0 0 0
The equality in the second line follows from the de…nition of mt : An asset pricing condition
for mt follows from applying Ito’s Lemma to the RHS and from subsequently equalizing

the resulting drift process to zero.26 The asset pricing condition for mt is:
1
+ (" 1) t ( + )+ m;t =0:
mt
The expected marginal production costs bt satis…es that:

Z 1 Z s 1+
ls 1
bt = Et exp [" s~ ( + )] d~
s ds :
t t l !s
Let Gb;t denote the gain process:

Z 1 Z s 1+
ls 1
Gb;t Et exp [" s~ ( + )] d~
s ds
0 0 l !s
Z t Z s 1+ Z t
ls 1
= exp [" s~ ( + )] d~
s ds + exp [" s~ ( + )] d~
s bt :
0 0 l !s 0
The equality in the second line follows from the de…nition of bt : The asset pricing condition
for bt is:
1+
lt 1 1
+" t ( + )+ b;t =0:
l ! t bt
PDEs and The Numerical Method

The PDEs follows from the asset pricing conditions for mt and bt : The PDEs is:
1 1 2
+ (" 1) ( + ) + "m; + "m;! ! + "m ; "m; =0
m 2
1+
l 11 1 2
+" ( + ) + "b; + "b;! ! + "b ; "b; =0:
l !b 2
The independent variables in the PDEs are ! and : The dependent variables are m and
b:
To solve for the PDEs, I use spectral methods. Speci…cally, I interpolate mappings m
and b with a linear combination of Chebyshev Polynomials of the First Kind. I evaluate the
interpolation at the Tensor basis (i.e., Tensor product plus Cartesian product of Chebyshev
26
The drift process of the gain process Gm;t is null, because Gm;t is the conditional expectation of a
random variable.

nodes) using a grid with 15 15 points. I use a nonlinear solver to …nd the coe¢ cients
associated with the Chebyshev Polynomials in the linear combination. I use as initial guess
the mappings m0 and b0 corresponding to the traditional mandate. That is,
Z 1 Z s
m0 (!; ) = exp [(" 1) s~ ( + )] d~
s ds
t t
Z 1 Z s
1
b0 (!; ) = exp [" s~ ( + )] d~
s ds;
t t !s
with initial state ! t = !:27 I compute the integrals in the RHS numerically.
27
Notice that m0 and b0 do not depend on the state :

Acknowledgements
I thank Nobuhiro Kiyotaki, Markus Brunnermeier, and Oleg Itskhoki for their invaluable guidance. I also thank Mark Aguiar, Quynh Anh
Vo, Wouter Den Haan, Ryo Jinnai, Anton Korinek, Fernando Mendo Lopez, Benjamin Moll, Stephanie Schmitt-Grohé, Andres Schneider,
Oreste Tristani, Christian Wolf, and seminar participants in the Princeton Macro/International Student Workshop and in the Princeton
Finance Student Workshop for useful comments and suggestions. Any remaining errors are my own.
Alejandro Van der Ghote

European Central Bank, Frankfurt am Main, Germany; email: [email protected]
© European Central Bank, 2018

Postal address 60640 Frankfurt am Main, Germany
Telephone +49 69 1344 0
Website www.ecb.europa.eu
All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced
electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the authors.
This paper can be downloaded without charge from www.ecb.europa.eu, from the Social Science Research Network electronic library or
from RePEc: Research Papers in Economics. Information on all of the papers published in the ECB Working Paper Series can be found
on the ECB’s website.
ISSN 1725-2806 (pdf) DOI 10.2866/35826 (pdf)
ISBN 978-92-899-3260-8 (pdf) EU catalogue No QB-AR-18-035-EN-N (pdf)

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Working Paper Series

Alejandro Van der Ghote Coordinating monetary and

No 2155 / June 2018

How to conduct macro-prudential regulation? How to coordinate monetary policy

ECB Working Paper Series No 2155 / June 2018 1

ECB Working Paper Series No 2155 / June 2018 2

ECB Working Paper Series No 2155 / June 2018 3

ECB Working Paper Series No 2155 / June 2018 4

ECB Working Paper Series No 2155 / June 2018 5

ECB Working Paper Series No 2155 / June 2018 6

ECB Working Paper Series No 2155 / June 2018 7

ECB Working Paper Series No 2155 / June 2018 8

2.1 Production in Goods Markets and Price-setting Behavior

ECB Working Paper Series No 2155 / June 2018 9

and it can therefore be interpreted as the aggregate price level.

ECB Working Paper Series No 2155 / June 2018 10

2.2 Investment Portfolios and Financial Intermediation

ECB Working Paper Series No 2155 / June 2018 11

qt kf;t = bt + nf;t Vt ; (8)

ECB Working Paper Series No 2155 / June 2018 12

being t 1 a common capital requirement across …nancial intermediaries. The capital

2.3 Portfolio Problems

dnf;t = dRf;t qt kf;t (it t ) bt dt; (11)

dpt =pt = t dt + 0dZt ;

ECB Working Paper Series No 2155 / June 2018 13

Et [dRf;t ] (it t ) dt + Covt [d t= t + dvt =vt ; dRf;t ] 0; (12)

with equality if the leverage constraint t qt kf;t =nf;t min f vt ; tg is slack.

ECB Working Paper Series No 2155 / June 2018 14

dnh;t = dRh;t qt kh;t + (it t) nh;t qt kh;t dt + wt lt dt + T rt dt ct dt; (15)

‡uctuations in Tobin’s Q to be driven only by ‡uctuations in E ~t dRn ;t :

ECB Working Paper Series No 2155 / June 2018 15

(it t ) dt = Et [d t= t] dt + Et [dct =ct ] V art [dct =ct ] : (17)

Et [dRh;t ] (it t ) dt + Covt [d t = t ; dRh;t ] 0; (18)

with equality if kh;t > 0:

2.4 Competitive Equilibrium

ECB Working Paper Series No 2155 / June 2018 16

De…nition 1 A competitive equilibrium is a set of stochastic processes adapted to the

4. fp ;t g satis…es the optimality condition (7) in the price-setting problem of …rms;

5. f t ; vt g satisfy optimality conditions (12) and (13) in the intermediaries’ portfolio

ECB Working Paper Series No 2155 / June 2018 17

3.1 The Leverage Multiple and Equilibrium Regions

ECB Working Paper Series No 2155 / June 2018 18

In Appendix B, I show the aggregate production function is Cobb-Douglas:

3.3 The Labor Wedge, Optimal Prices, and In‡ation Rate

ECB Working Paper Series No 2155 / June 2018 19

I show also that xt (yj ) =yj satis…es:

ECB Working Paper Series No 2155 / June 2018 20

4 Policy Mandates and Markov Equilibrium

ECB Working Paper Series No 2155 / June 2018 21

Traditional and Coordinated Mandate Under the traditional mandate, monetary

4.2 The Markov Competitive Equilibrium

De…nition 2 A Markov competitive equilibrium is a set of state variables and a set of

ECB Working Paper Series No 2155 / June 2018 22

Further Restrictions on Policy Rules To simplify the analysis, I restrict i and

5.1 Monetary Policy

ECB Working Paper Series No 2155 / June 2018 23

l=l and = 1 !" 1

independent of macro-prudential policy : The e¢ cient in‡ation rate maximizes the

ECB Working Paper Series No 2155 / June 2018 24

arg min ! = min ! :

Discussion of Commitment Assumption Monetary policy does not require com-

ECB Working Paper Series No 2155 / June 2018 25

5.2.1 Macro-prudential Policy in the Flexible Price Economy