Macroprudential policy in a Knightian uncertainty model with credit-, risk-, and leverage cycles

We study the impact of uncertainty on financial stability and the business cycle. We extend the work of Boz and Mendoza (2014) by endogenizing credit production, modifying learning mechanism into an adaptive set-up, as well as including financial and monetary policies. In our model households are (intrinsically) rational but take economic decisions under incomplete information. The incompleteness is not caused by their cognitive limitations, as in rational inattention theory (Sims, 2003). Households `learn by doing' and once a sufficient number of realizations of the state variable have materialized, and the incomplete information set is completed. This learning set-up is incorporated into a New Keynesian model with credit market frictions, extended to include uncertainty, where a share of households needs external financing to consume. Because of limited enforceability of financial contracts, households are required to provide collateral for their loans, and so the relationship between the bank and household is tightened for many periods ahead. We find in our framework the build up of risk, leverage, increase in consumption and price of collateral takes longer than in other DSGEs with standard financial friction models. We also find that both the frequency and the amplitude of expansions and contractions are asymmetric - recessions are less frequent and deeper than expansions. Moreover, we find that boom-bust cycles occur as rare events. Using the Cogley and Sargant's (2008) definition of a severe(or systemic) crisis, we find on average two such events per century. We also find that, different from standard boom-bust cycles, a systemic crisis can be followed by a sequence of subsequent contractions, as it makes the economy more unstable. The result is asymmetric distributions of key macroeconomic and financial variables, with high skewness and fat tails. Lastly, we also find that, by reducing the amount of borrowing and leverage in upturns, the LTV-ratio regulation is effective in smoothing the cycles and reducing the effects of a deep contraction on the real-financial variables. We also discuss the role of macroprudential policy in reducing information incompleteness by generating information that helps the agent learn faster the new environment, or provide a smoother transition to the new economic environment.