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 that case, an instrument more directly targeted at the microeconomic distortion would be to increase the risk-weights attached to such lending when computing banks’ required capital. And, as we have seen in the present crisis, much of the action may take place outside the regulated banking system in the wider credit markets. In that case, varying margin requirements might be a more appropriate instrument for dealing with vulnerabilities building up in the capital markets more generally. Finally, there is the option of introducing direct constraints on the terms or availability of credit, for instance imposing maximum loan-to-value ratios in the mortgage market. The best approach seems likely to involve a portfolio of instruments. And while experience of the use of these tools may be limited, it is not entirely a tabula rasa. In particular, a number of developing and emerging economies have experience in applying some of these instruments, while there are also lessons to be drawn from the past experience of some advanced economies too. Our aim here, though, is not to analyse the optimal design of the macro-prudential policy toolkit, but rather to consider how the deployment of such instruments might affect the conduct of monetary policy. As yet, there has been relatively little analysis of how the operation of macro-prudential policy might interact with monetary policy. We explore two related issues. First, both monetary policy and macro-prudential policy are likely to affect both aggregate demand and supply on the one hand and conditions in the banking sector on the other.