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Managing Financial Crises: Lean or Clean?

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  • Takayuki Tsuruga

    (Kyoto Unviersity)

  • Ryo Kato

    (Bank of Japan)

  • Mitsuru Katagiri

    (Bank of Japan)

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Abstract

This paper discusses the lean vs. clean policy debate in managing financial crises based on dynamic general equilibrium models with an occasionally binding collateral constraint. We show that a full state-contingent subsidy for debtors can restore the first-best allocations by forestalling disorderly deleveraging in a crisis. While this result appears to favor the clean policy against a lean policy that achieves the second-best allocation, further assessment points to various risks associated with the clean policy from a practical viewpoint. First, the optimal clean policy is likely to call for an unrealistically large amount of fiscal resources. Second, if the clean policy is activated with an empirically realistic intervention, the less-than-optimal clean policy incentivizes debtors to take on undue risks, exposing the economy to higher crisis probabilities. Finally, the less-than-optimal clean policy may give rise to huge welfare losses due to the policy maker's misrecognition of the state of the economy.

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Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 355.

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Date of creation: 2013
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Handle: RePEc:red:sed013:355

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  1. Luis Felipe Céspedes & Roberto Chang & Diego Saravia, 2011. "Monetary Policy under Financial Turbulence: An Overview," Central Banking, Analysis, and Economic Policies Book Series, in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.), Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 1, pages 001-021 Central Bank of Chile.
  2. Edward J. Frydl, 1999. "The Length and Cost of Banking Crises," IMF Working Papers 99/30, International Monetary Fund.
  3. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2010. "Financial Crises and Macro-Prudential Policies," CEP Discussion Papers dp1032, Centre for Economic Performance, LSE.
  4. Gianluca Benigno & Huigang Chen & Chris Otrok & Alessandro Rebucci & Eric Young, 2010. "Revisiting Overborrowing and Its Policy Implications," CEP Discussion Papers dp1020, Centre for Economic Performance, LSE.
  5. John B. Taylor, 2009. "The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong," NBER Working Papers 14631, National Bureau of Economic Research, Inc.
  6. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  7. Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "Banking Crises: An Equal Opportunity Menace," NBER Working Papers 14587, National Bureau of Economic Research, Inc.
  8. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
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