implementation of a countercyclical capital buffer ranging from 0 to 2.5 percent of risk-weighted assets. Overall, total capital requirements would rise from a minimum of 8 percent of risk-weighted assets today under Basel II up to 13 percent when the maximum value for the countercyclical capital buffer is taken into account (BCBS, 2011).

Macroprudential instruments can be discussed in a time-series dimension or in cross-section (Borio, 2010), mirroring the types of macrofinancial risks mentioned previously. When systemic behavior over time is considered, the key issue is how risks can be amplified by interactions within the financial system and between the financial system and the real economy. As discussed, such feedback loops are a crucial component of endogenously generated business cycles. In its turn, the cross-section dimension relates to the common exposure of institutions at each point of time. Correlated assets, or even counterparty interrelations, create such a link among financial institutions.

Table 1 shows a typology of macroprudential instruments offered by Galati and Moessner (2011). Whether macroprudential instruments are expected to tackle time-series or cross-section dimensions, they overlap with microprudential ones.

Can we reduce financial instability without using monetary policy, relying only on prudential and regulatory rules incorporating macrofinancial risks? Would that guarantee both financial and macroeconomic stability? Most practitioners have expressed the view that a combined (articulate) use of both monetary and macroprudential policies and rules is superior to a stand-alone implementation of either (Canuto, 2011a). Instead of “a corner solution where one instrument is devoted entirely to one objective, the macro-stabilization exercise must be viewed as a joint optimization problem where monetary and regulatory policies are used in concert in pursuit of both objectives” (CIEPR, 2011, p.7). Prudential rules and monetary policy are parameters to each other, as their standalone stances affect the evolution of asset prices. Therefore, a joint optimization pursuit is likely superior to isolated “corner solutions”.

In the time-series dimension of macroprudential issues, monetary policy and macroprudential tools can clearly be complementary in reducing procyclicality. For example, during simultaneous asset price and macroeconomic booms, one could combine higher contingent capital requirements and additional liquidity surcharges with interest rate hikes. Because of the imperfect substitutability between these measures, the greatest effectiveness should be considered when calibrating jointly their intensities.<sup>**9**</sup>

> **9** Appropriate models that account for how macroprudential tools affect monetary policy transmission are fundamental to such coordinated policies. Bean et al (2010) show that variations on incentives to banks’ capital offer better outcomes than the standalone use of monetary policy to lean against bubbles. Agénor et al (2011) develop a general-equilibrium framework for analyzing a similar issue. They conclude that if monetary policy can react strongly to deviations of inflation from target, the best policy is an aggressive augmented interest rate rule— regardless of the degree of persistence in the policy rate.  If monetary policy cannot react sufficiently strongly (because the central bank fears destabilizing markets by raising interest rates sharply while inflation remains subdued, for instance), combining a credit-augmented interest rate rule and a countercyclical capital regulatory rule is optimal for promoting economic stability.

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