Macroprudential Policy in the Presence of External Risks

We characterize optimal macroprudential policy in response to external risks---shocks to the level and volatility of world interest rates--in a small open economy subject to financial crises. Low and stable world interest rates reinforce overborrowing arising from a pecuniary externality generated by collateral constraints that depend on asset prices. We show that this mechanism leads to greater exposure to crises typically accompanied by abrupt increases in interest rates and a persistent rise in their volatility, as commonly observed for crises in emerging market economies. A tax on international borrowing implementing the optimal policy depends on two factors, the incidence and severity of future crises. We show that the interaction of these factors implies that the tax responds to external risks even though equilibrium allocations do not, and that it does so non-monotonically with respect to the direction of external shocks|higher macroprudential taxes are not always the optimal policy in response to an increase in external risks|.