The paper examines a Minsky cycle starting with a boom with rising asset prices and leverage followed by a Minsky moment where asset prices fall, hurting the real economy. Phases of the boom may be driven by non-rational extrapolative expectations. Extrapolative expectations is the idea that investor expectations of future stock returns correlate with past returns and level of the stock market.
Motivation for macroprudential policies include financial fragility, aggregate demand stabilization, and monetary policy constraints. Financial decisions (such as borrowing, lending, risk-taking) at time 0 impact the following macro impact bust period 1. Macroprudential policies should therefore regulate financial decisions since aggregate demand externalities need to be considered. And while monetary policy could also lean against it, it is exhausted in the bust period 1 since it hits a zero lower bound (ZLB). In the final period, the payoff of the risky asset is realized.
Targets include the macroeconomic goal of the current recession and financial stability goal. There is a tradeoff between these goals and the instruments available.
Level of debt from time 0 to 1 is going to negatively impact asset price at time 1 and there is a one to one relationship between that asset price and output. A more indebted economy will lead to lower asset prices at time 1, which creates a drag on the Main Street economy. The intuition is that higher debt lowers risk-taking capacity, which demands a higher risk premium. This then lowers asset price and lowers consumption. Risk in the final period and incomplete markets are key to this effect.
Absent macroprudential tools, monetary policy should lean against the economy at time 0 in order to reduce the bust at time 1. If macroprudential tools are available, one should use them to limit leverage at time 0 in a world with rational expectations. In this case, monetary policy can purely focus on price stability. With extrapolative expectations, one should lean against the economy – widen the output gap at time 0 – in order to reduce asset price increase from time -1 to 0 and make borrowers less exuberant in leveraged risk taking at time 0.