We focus on the case of a mark-up shock since this generates the most interesting results; for TFP and financial “panic” shocks the micro-prudential instrument alone generates good outcomes. In this instance, the single policy maker can achieve similar outcomes for the output and capital gaps to that under full commitment (black dotted line) but has to live with a somewhat higher level of inflation. The main difference in the policy setting occurs in the first period because the policy maker cannot manipulate leverage to the same degree through the future reversal of the policy rate and the bank levy that occurs under commitment. For later periods, the paths of the nominal interest rate and the bank levy are close, with higher nominal interest rates moderated by a lower bank levy. Next we consider the potential co-ordination problems when the two instruments are set by different policy makers, where to mimic delegation each is assigned only a part of the social objective function. So the monetary policy maker is given an objective over just the variances of inflation and output, with weights of unity and 0.01, while the macro-prudential policy maker is given one defined over the capital gap and the output gap, also with weights of unity and 0.01. 14 The solid blue line in Chart 9 shows the outcome of the resulting Nash game. Unsurprisingly, the capital gap is considerably narrower than under the single policy maker, because it is so prominent in the objective function of the macro-prudential policy maker.
On the other hand, there are those who reject these arguments and argue that the reduced effectiveness of monetary policy at the ZLB and during a credit crisis makes this the only effective macroeconomic policy weapon at the current juncture. Whatever the resolution of this debate, however, the traditional arguments against activist fiscal policies seem likely to still obtain once normal times return. 2. The choice of monetary instrument. Given the above, monetary policy is likely once more to take on the primary role in short-term aggregate demand management once normal times return. But the apparent effectiveness of asset purchases at altering longer-term yields opens up the possibility that they could become part of the monetary toolkit in normal times. We argued in Section 3 that despite its apparent effectiveness, there were good reasons to return to exclusive reliance on a shortterm policy rate in normal times and after any asset purchases during the crisis have been appropriately unwound. 3. The monetary transmission mechanism. The crisis has brutally exposed the limitations of conventional macroeconomic analysis ignoring the role of financial intermediaries. While the existing literature contained a strand focussing on the role of financial frictions – including those on the broad credit channel – they generally focussed on those that arose from the behaviour of borrowers. The crisis has illustrated the need to take seriously the incentives facing the intermediaries themselves.