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Optimal Time-Consistent Macroprudential Policy

Author

Listed:
  • Enrique Mendoza

    (University of Pennsylvania)

  • Javier Bianchi

    (Federal Reserve Bank of Minneapolis)

Abstract

Collateral constraints widely used in models of financial crises feature a pecuniary externality, because agents do not internalize how collateral prices respond to collective borrowing decisions, particularly when binding collateral constraints trigger a crisis. We study a production economy in which physical assets serve as collateral for debt and working capital loans, and show that agents in a competitive equilibrium borrow ``too much" during credit expansions compared with a financial regulator who internalizes this externality. Under commitment, however, this regulator faces a time inconsistency problem: It promises low future consumption to prop up current asset prices when collateral constraints bind, but this is not optimal ex post. Instead, we examine the optimal, time-consistent policy of a regulator who cannot commit to future policies. Quantitative analysis shows that this policy reduces the incidence and magnitude of crises, removes fat tails from the distribution of returns and reduces risk premia. A key element of this policy is a state-contingent macro-prudential debt tax (i.e. a tax imposed in normal times when a financial crisis has positive probability next period) of about 1 percent on average. Constant debt taxes also reduce the frequency of crises but are less effective at reducing their severity and reduce welfare when credit constraints bind.

Suggested Citation

  • Enrique Mendoza & Javier Bianchi, 2015. "Optimal Time-Consistent Macroprudential Policy," 2015 Meeting Papers 289, Society for Economic Dynamics.
  • Handle: RePEc:red:sed015:289
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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