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Spillovers, capital flows and prudential regulation in small open economies

  • Paul Castillo

    (Banco Central de Reserva del Perú)

  • Cesar Carrera

    (Banco Central de Reserva del Perú)

  • Marco Ortiz

    (Banco Central de Reserva del Perú)

  • Hugo Vega

    (Banco Central de Reserva del Perú)

This paper extends the model of Aoki et al. (2009) considering a two sector small open economy. We study the interaction of borrowing, asset prices, and spillovers between tradable and non-tradable sectors. Our results suggest that when it is difficult to enforce debtors to repay their debt unless it is secured by collateral, a productivity shock in the tradable sector generates an increase in asset prices and leverage that spills over to the non-tradable sector, generating an appreciation of the real exchange and an increase in domestic lending. Macro-prudential instruments are introduced under the form of cyclical loan-to-value ratios that limit the amount of capital that entrepreneurs can pledge as collateral. Cyclical taxes that respond to the movements in the price of non-tradable goods are analysed. Simulation results show that this type of instruments significantly lessen the amplifying effects of borrowing constraints on small open economies and consequently reduce output and asset price volatility.

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Paper provided by Peruvian Economic Association in its series Working Papers with number 2014-10.

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Date of creation: Mar 2014
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Handle: RePEc:apc:wpaper:2014-010
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