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Sudden Floods, Prudential Regulation and Stability in an Open Economy

  • Pierre-Richard Agénor
  • K. Alper
  • L. Pereira da Silva

We develop a dynamic stochastic model of a middle-income, small open economy with a two-level banking intermediation structure, a risk-sensitive regulatory capital regime, and imperfect capital mobility. Firms borrow from a domestic bank and the bank borrows on world capital markets, in both cases subject to an endogenous premium. A sudden flood in capital flows generates an expansion in credit and activity, and asset price pressures. Countercyclical regulation, in the form of a Basel III-type rule based on real credit gaps, is effective at promoting macroeconomic stability (defined in terms of the volatility of a weighted average of inflation and the output gap) and financial stability (defined in terms of the volatility of a composite index of the nominal exchange rate and house prices). However, because the gain in terms of reduced volatility may exhibit diminishing returns, a countercyclical regulatory rule may need to be supplemented by other, more targeted, macroprudential instruments.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps267.pdf
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Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 267.

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Date of creation: Feb 2012
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Handle: RePEc:bcb:wpaper:267
Contact details of provider: Web page: http://www.bcb.gov.br/?english

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  1. Lawrence J. Christiano & Mathias Trabandt & Karl Walentin, 2010. "Introducing financial frictions and unemployment into a small open economy model," FRB Atlanta CQER Working Paper 2010-04, Federal Reserve Bank of Atlanta.
  2. Senay, Ozge, 2008. "Disinflation And Exchange-Rate Pass-Through," Macroeconomic Dynamics, Cambridge University Press, vol. 12(02), pages 234-256, April.
  3. Agénor, P.-R. & Alper, K. & Pereira da Silva, L., 2012. "Capital requirements and business cycles with credit market imperfections," Journal of Macroeconomics, Elsevier, vol. 34(3), pages 687-705.
  4. Benigno, Pierpaolo, 2001. "Price Stability with Imperfect Financial Integration," CEPR Discussion Papers 2854, C.E.P.R. Discussion Papers.
  5. Kollmann, Robert, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," Journal of International Economics, Elsevier, vol. 55(2), pages 243-262, December.
  6. Shi, Kang & Xu, Juanyi, 2010. "Intermediate goods trade and exchange rate pass-through," Journal of Macroeconomics, Elsevier, vol. 32(2), pages 571-583, June.
  7. Carvalho, Alexandre & Moura, Marcelo L., 2008. "What Can Taylor Rules Say About Monetary Policy in Latin America?," Insper Working Papers wpe_126, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
  8. Rodrigo Caputo & Felipe Liendo & Juan Pablo Medina, 2007. "New Keynesian Models for Chile in the Inflation-Targeting Period," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 13, pages 507-546 Central Bank of Chile.
  9. David Cook & Woon Gyu Choi, 2002. "Liability Dollarization and the Bank Balance Sheet Channel," IMF Working Papers 02/141, International Monetary Fund.
  10. Pierre-Richard Agénor & Koray Alper, 2009. "Monetary Shocks and Central Bank Liquidity with Credit Market Imperfections," Centre for Growth and Business Cycle Research Discussion Paper Series 120, Economics, The Univeristy of Manchester.
  11. Elekdag, Selim & Tchakarov, Ivan, 2007. "Balance sheets, exchange rate policy, and welfare," Journal of Economic Dynamics and Control, Elsevier, vol. 31(12), pages 3986-4015, December.
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