This paper develops a model featuring both a macroeconomic and a financial friction that
speaks to the interaction between monetary and macro-prudential policies. There are two main
results. First, real interest rate rigidities in a monopolistic banking system have an asymmetric
impact on financial stability: they increase the probability of a financial crisis (relative to the
case of flexible interest rate) in response to contractionary shocks to the economy, while they
act as automatic macro-prudential stabilizers in response to expansionary shocks. Second, when
the interest rate is the only available policy instrument, a monetary authority subject to the same
constraints as private agents cannot always achieve a (constrained) efficient allocation and faces
a trade-off between macroeconomic and financial stability in response to contractionary shocks.
An implication of our analysis is that the weak link in the U.S. policy framework in the run up
to the Global Recession was not excessively lax monetary policy after 2002, but rather the
absence of an effective regulatory framework aimed at preserving financial stability.
This paper surveys dynamic stochastic general equilibrium models with financial frictions in use by central banks and discusses priorities for future development of such models for the purpose of monetary and financial stability analysis. It highlights the need to develop macrofinancial models which allow analysis of the macroeconomic effects of macroprudential policy tools and to evaluate elements of the Basel III reforms as a priority. The paper also reviews the main approaches to introducing financial frictions into general equilibrium models.