1. Financial intermediation and the real
economy: implications for monetary and
macroprudential policies
Stefano Neri
Banca d’Italia
SUERF/Deutsche Bundesbank/IMFS Conference
The ESRB at 1
Berlin, 8-9 November 2011
sual disclaimer applies

2. Outline
1. The financial crisis and the debate on
modelling
2. Towards a new framework?
3. Monetary and macroprudential policies in
a model with financial intermediation

3. Pre-crisis consensus on macro modelling
• New Keynesian framework
 Representative agent cash-less economy
 nominal rigidities → role for monetary policy
 no financial frictions and no intermediaries
• “The paradigm that has emerged […] is one that is
clearly applicable to normal times […] in developed,
stable economies”, J. Galí (interview for EABCN, 2009)
• Estimated models (e.g. Smets and Wouters, 2007)
used for policy analysis (e.g. RAMSES at Riksbank )

4. The financial crisis
• The crisis showed how
 important are the links between financial
markets and the real economy
 many of the assumptions that characterized the
new Keynesian framework were wrong
 financial markets are far from being efficient
 financial markets matter in originating and
propagating shocks

5. Intense debate on the lessons of the crisis
for economics and economic modelling
• Buiter, Goodhart, Cecchetti, Spaventa and De
Grauwe to mention some of critics of DSGE models
• Main missing elements:
 financial intermediation
 insolvency and default
 liquidity
 regulation of intermediaries and markets
 booms and busts in asset markets

6. The crisis as an opportunity
• Crisis as opportunity to modify current framework
• Since Kiyotaki and Moore (1997) and Bernanke et
al. (1999), few papers have considered financial
intermediation in general equilibrium
• Intensive research ongoing since 2009
 Angeloni and Faia, Curdia and Woodford, Gertler and
Kiyotaki, Bianchi and Mendoza, Jeanne and Korinek,…
• They all fall short of modelling systemic risk

7. Towards a new framework?
• Setting up a new framework that takes into
account the critiques that have been raised will
require time
• Policy-makers are confronted with questions that
require timely answers
• Researchers in both academia and central banks
to cooperate and develop new models
• In the meantime, one possibility is to modify
current models and use them for policy analysis

8. Monetary and macroprudential policies in a
model with financial intermediation
I use the model developed in Gerali et al. (2010) and
modified in Angelini et al. (2011) to answer questions
related to monetary and macroprudential policies
1) What was the impact of the financial crisis on
economic activity in the euro area?
2) Should monetary and macroprudential policies
co-operate? (BI Discussion paper, no. 801, 2011)
3) Should macroprudential policy lean against
financial cycles?

9. The model
• Based on Gerali, Neri, Sessa and Signoretti (2010)
“Credit and Banking in a DSGE model of the euro area”
• Medium-scale model with:
 real and nominal rigidities (Smets and Wouters, 2007)
 financial frictions à la Kiyotaki and Moore (1997)
 monopolistic competition in banking sector
 slow adjustment of bank rates to policy rate
 role for bank capital
 time-varying risk weights in bank capital regulation
 policy rule for bank capital requirement

10. The model (cont’d)
• Project started in September 2007
• Model has been estimated using Bayesian
methods and data for the euro area over the
period 1998-2009
• The model has also been used to study:
 impact of a credit crunch on euro-area economy
 impact of higher capital requirements (Basel 3)
• Model has some of the limitations that I have
discussed

11. Modelling monetary and
macroprudential policies
• Monetary policy:
 interest rate rule à la Taylor
Rt = (1 − ρ R ) R + (1 − ρ R ) [ χ π ( π t − π ) + χ y ( yt − yt −1 ) ] + ρ R Rt −1
• Macroprudential policy:
 bank capital requirements rule
ν t = (1 − ρν )ν + (1 − ρν ) χν X t + ρνν t −1
 Xt can be any macroeconomic variable relevant for
macroprudential authority

12. What was the impact of the financial crisis
on economic activity in the euro area?
• The recession in
2009 was almost
entirely caused by
adverse shocks to
banking sector
• The sharp
reduction of policy
rates attenuated
the strong and
negative effect of
the crisis on the
euro-area
economy

13. Should monetary and macroprudential
policies co-operate?
C a pita l re q uire m e nts P o licy rate
• In “normal” times 9 .1 0 .0 2
0 .0 0
macroprudential
9 .0
-0 .02
8 .9
policy yields small 8 .8
-0 .04
-0 .06
benefits 8 .7
0 10 20 30 40
-0 .08
0 10 20 30 40
• If two authorities do 9 .0 0
C a p ital/a sse ts ra tio
0 .3
L o a n rate
not cooperate, policy 8 .7 5 0 .2
tools are extremely 8 .5 0 0 .1
volatile 8 .2 5 0 .0
• Benefits are sizeable
8 .0 0 -0 .1
0 10 20 30 40 0 10 20 30 40
when economy is hit
L o a n s-to -o u tp u t ra tio O u tp u t
0 .2 0 .0
by financial shocks
0 .0
-0 .1
-0 .2
and when two -0 .4
-0 .2
authorities cooperate -0 .6
0 10 20 30 40
-0 .3
0 10 20 30 40
quarters after shock quarters after shock
Cooperative Non cooperative Only monetary policy

14. Should macroprudential policy lean against
financial cycles?
• Agents expect a
Capital requirements Policy rate (dev. from steady state)
9.5 0 0 .2
reduction in aggregate 9.4 0
0 .0
risk in one year time
9.3 0
• For a given target for
9.2 0 -0.2
9.1 0
leverage, this provides 9.0 0
-0.4
an incentive for banks 8.9 0
0 5 10 15 20
-0.6
0 5 10 15 20
to increase lending
• Shock does not 0.2 5
Output (% dev. from steady state)
2 .0
Loans-to-output ratio (dev. from steady state)
Active macroprudential policy
materialize 0.2 0
1 .5
No macroprudential policy
• Tighter capital 0.1 5
requirements can be 0.1 0
1 .0
effective in containing 0.0 5
0 .5
expansion of lending 0.0 0 0 .0
0 5 10 15 20 0 5 10 15 20
q uarte rs afte r s ho c k q uarte rs afte r s ho c k

15. Implications for monetary and
macroprudential policies
 Aggressive monetary policy can help mitigating
negative impact of shocks to banking sector
 Monetary and macroprudential policies should
closely co-operate
 Benefits of macroprudential policy can be sizeable
when economy is hit by financial shocks
 Risk of coordination failure
 Macroprudential policy can be effective in leaning
against financial cycles

16. Conclusions
• DSGE models have undergone severe criticism
• No doubt that models must be improved, but
working alternative missing
• Intensive research ongoing
• Modeling systemic risk is key
• Meanwhile, we can adapt current models with a role
for financial intermediation to address questions
related to monetary and macroprudential policies