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Monetary and Macro-Prudential Mandates in a New Keynesian Behavioural Framework

This paper examines the conduct of optimal monetary and macro-prudential mandates in a behavioural bounded rationality framework with a financial friction in form of the collateral constraint. A mandate framework is designed where each macroeconomic regulator is assigned a distinct objective function, is instrument-independent and the welfare-optimal parameters of these delegated mandate are computed. Cooperative and non-cooperative mandates games between the monetary and macro-prudential regulation are studied and comparisons drawn between results for rational expectations (RE) and BR models. The main results are: first, in a Bayesian likelihood race the BR model easily outperforms the RE model. Second, the BR model has much larger region of determinacy compared with RE; i.e., the Taylor principle is easier to satisfy under BR. Third, forward guidance is much less powerful under the BR model; i.e., the “forward-guidance puzzle" is resolved. Finally, we confirm a common result in this literature that monetary and macro-prudential cooperation is welfare reducing compared with non-cooperation.