Consequently, an increase in credit supply resulting from a relaxation in this incentive compatibility constraint provides both an indirect boost to output contemporaneously and a direct boost through a higher capital stock in the following period. There are two policy instruments. The first is monetary policy, which operates by changing the deposit rate and the associated loan-deposit spread. The second is a (lump-sum) levy/subsidy on the banking sector, which can be used to manipulate the amount of capital that banks carry forward into the next period. Of course, this is not how macro-prudential policy is expected to function in practice. But the model acts as a useful metaphor for thinking how policies that alter the buffer of capital available to banks might affect the dynamics of the economy and the conduct of monetary policy. Both monetary and macro-prudential policies affect the incentive compatibility constraint (1) and are therefore essentially alternative ways of expanding the supply of credit and with it the volume of investment. With sticky prices, a reduction in the policy rate by the monetary authority lowers the real deposit rate, raises the loan-deposit spread, increases equilibrium leverage and raises the quantity of loans. And a change in available bank capital as a result of the macro-prudential authority’s decisions translates directly into a higher volume of loans at the existing leverage ratio. But monetary policy also has an independent effect on aggregate demand by encouraging intertemporal substitution in consumption. This is not operative with macro-prudential policy.
In fact, the spill-over effects transmitted from one region of the world to another via interest rates, exchange rates and equity prices, for instance, can be mitigated through closer regional integration. By reducing the relative degree of economic and financial openness of the regions concerned, such integration can be an effective instrument to shield them from external shocks, thereby obviating the need for trade or capital restrictions. The European experience shows that regional integration can be beneficial in this respect. The euro area weathered well the economic slowdown and financial market uncertainties arising from the series of balance of payments crises seen between 1997 and 1999. Likewise, provided that the current economic slowdown in the United States does not develop into a hard landing, the euro area is expected to record in 2001 above-potential growth for the second year in a row. To be sure, sheltering domestic economies from external shocks was not the primary consideration of European integration when it was initiated almost 50 years ago. Nor were the creation of the euro and the setting-up of the European Central Bank (ECB) objectives at that time. These are, in fact, only the latest developments in a long process of regional integration that started and is continuing with a strong political commitment.