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Optimal policy for macro-financial stability

  • Gianluca Benigno
  • Huigang Chen
  • Chris Otrok
  • Alessandro Rebucci
  • Eric Young

In this paper we study whether policy makers should wait to intervene until a financial crisis strikes or rather act in a preemptive manner. We study this question in a relatively simple dynamic stochastic general equilibrium model in which crises are endogenous events induced by the presence of an occasionally binding borrowing constraint as in Mendoza (2010). First, we show that the same set of taxes that replicates the constrained social planner allocation could be used optimally by a Ramsey planner to achieve the first best unconstrained equilibrium: in both cases without any precautionary intervention. Second, we show that the extent to which policymakers should intervene in a preemptive manner depends critically on the set of policy tools available and what these instruments can achieve when a crisis strikes. For example, in the context of our model, we find that, if the policy tools is constrained so that the first best cannot be achieved and the policy make r has access to only one tax instrument, it is always desirable to intervene before the crisis regardless of the instrument used. If however the policy maker has access to two instruments, it is optimal to act only during crisis times. Third and finally, we propose a computational algorithm to solve Markov-Perfect optimal policy for problems in which the policy function is not differentiable.

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File URL: http://eprints.lse.ac.uk/51519/
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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 51519.

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Length: 50 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:ehl:lserod:51519
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  1. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 15114, University Library of Munich, Germany.
  2. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2012. "Financial Intermediation, Exchange Rates, and Unconventional Policy in an Open Economy," NBER Working Papers 18431, National Bureau of Economic Research, Inc.
  3. Adam, Klaus & Billi, Roberto M., 2004. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Working Paper Series 0377, European Central Bank.
  4. Adam, Klaus & Billi, Roberto M., 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," CFS Working Paper Series 2005/16, Center for Financial Studies (CFS).
  5. Kim, Sunghyun Henry & Kollmann, Robert & Kim, Jinill, 2010. "Solving the incomplete market model with aggregate uncertainty using a perturbation method," Journal of Economic Dynamics and Control, Elsevier, vol. 34(1), pages 50-58, January.
  6. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  7. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2012. "Capital Controls or Exchange Rate Policy? A Pecuniary Externality Perspective," CEP Discussion Papers dp1160, Centre for Economic Performance, LSE.
  8. 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.
  9. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  10. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004," CEPR Discussion Papers 5644, C.E.P.R. Discussion Papers.
  11. Guillermo A. Calvo & Alejandro Izquierdo & Luis-Fernando Mejía, 2008. "Systemic Sudden Stops: The Relevance Of Balance-Sheet Effects And Financial Integration," NBER Working Papers 14026, National Bureau of Economic Research, Inc.
  12. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  13. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  14. repec:ner:tilbur:urn:nbn:nl:ui:12-3107633 is not listed on IDEAS
  15. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  16. Timothy J. Kehoe & Kim J. Ruhl, 2008. "Are Shocks to the Terms of Trade Shocks to Productivity?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 804-819, October.
  17. Krusell, Per, 2002. "Time-consistent redistribution," European Economic Review, Elsevier, vol. 46(4-5), pages 755-769, May.
  18. Jonathan D. Ostry & Carmen M. Reinhart, 1992. "Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 495-517, September.
  19. Jeanne, Olivier & Rancière, Romain, 2008. "The Optimal Level of International Reserves For Emerging Market Countries: A New Formula and Some Applications," CEPR Discussion Papers 6723, C.E.P.R. Discussion Papers.
  20. Enrique G. Mendoza, 2010. "Sudden Stops, Financial Crises, and Leverage," American Economic Review, American Economic Association, vol. 100(5), pages 1941-66, December.
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