Macroprudential policy in the presence of external risks

We document the relevance of external risks—shocks to the level and volatility of world interest rates—in shaping economic activity in emerging market economies (EMEs) and characterize optimal macroprudential policy in response to these risks in a small open economy subject to financial crises. Low and stable 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 observed during sudden stops in EMEs. A tax on international borrowing that implements a social planner's optimal policy can be decomposed into three factors: the severity of future crises, the ability of the planner to dampen future crises, and the incidence of future crises. We show that the effects of interest rate volatility on these factors implies that, qualitatively, the tax responds non-monotonically with respect to the direction of volatility shocks and that, quantitatively, increasing macroprudential taxes is seldom the optimal response to an increase in interest rate volatility.