Unpleasant Monetarist Arithmetic: Macroprudential Edition

The 2008 crisis highlighted the linkages between the financial sector and the real
economy, as well as between the corresponding stabilization policies: macroprudential
and monetary (M&Ms). Our game-theoretic analysis focuses on the increasingly adopted
separation setup, in which M&Ms are conducted by two different institutions (e.g. in
Australia, Canada, Eurozone, Sweden, Switzerland and the United States). We show
that separated policy M&Ms are not as sweet as their chocolate counterparts, in fact they
may turn sour. The main reason is that a strategic conflict is likely to arise between the
autonomous prudential authority and the central bank in addressing exuberant credit
booms, such as those during 1998-2000, 2003-2006 and 2011-2016. In this conflict -
that manifests as the Game of Chicken under some parameter values - each institution
prefers a different policy regime. In particular, both the prudential authority and the
central bank prefer to do nothing about the credit boom and induce the other institution
to respond instead; arguably the case of Sweden, Norway and other countries post-
2010. To allow for richer strategic interactions, we postulate the concept of Stochastic
leadership, which generalizes Stackelberg leadership and simultaneous move game by
allowing for Calvo-type probabilistic revisions of policy actions. We show that the most
likely outcomes are Policy Deadlock, Regime Switching and Macroprudential
Dominance, but all three are socially undesirable. This is not only because of excessive
financial and economic cycles, but also because monetary policy coerced into leaning
against the wind loses full control over price inflation. The separation setup of M&Ms is
thus subject to a macroprudential version of unpleasant monetarist arithmetic.