Monetary shocks, macroprudential shocks and financial stability*

- We study the effects of monetary and macroprudential shocks on financial stability.
- A contractionary monetary shock increases financial fragility.
- A macroprudential shock does not reduce the debt burden with interest rates fixed.
- If interest rates can adjust, a macroprudential shock can reduce financial fragility.
- Policy coordination may help to achieve financial stability.

This paper examines the implications of monetary shocks and macroprudential shocks for aggregate financial fragility using a sign restricted VAR model estimated with US data spanning the period 1960Q1-2007Q4. Contractionary monetary shocks are found to exacerbate financial fragility, increasing both the credit to GDP ratio and the 'financial ratio', which is the ratio of firms' debts to their internal funds. By contrast, when interest rates are fixed, credit-constraining macroprudential shocks may be able to reduce the credit to GDP ratio in the short run but are not able to reduce the financial ratio. However, when the interest rate is free to accommodate the macroprudential shock, both the credit to GDP ratio and the financial ratio decline, indicating a reduction of financial fragility and suggesting that there may be gains from a coordinated approach to macroeconomic management.