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Optimal Policy for Macro-Financial Stability

  • Gianluca Benigno
  • Huigang Chen
  • Christopher Otrok
  • Alessandro Rebucci

    ()

  • Eric Young

This paper studies whether policymakers should wait to intervene until a financial crisis strikes or rather act in a preemptive manner. This question is examined 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, the paper shows 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, the paper shows 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 the model, it is found that, if the policy tools are constrained so that the first best cannot be achieved and the policymaker has access to only one tax instrument, it is always desirable to intervene before the crisis regardless of the instrument used. If, however, the policymaker has access to two instruments, it is optimal to act only during crisis times. Third and finally, the paper proposes a computational algorithm to solve Markov-perfect optimal policy for problems in which the policy function is not differentiable.

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Paper provided by Inter-American Development Bank, Research Department in its series Research Department Publications with number 4818.

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Date of creation: Dec 2012
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Handle: RePEc:idb:wpaper:4818
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  1. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2012. "Capital controls or exchange rate policy? A pecuniary externality perspective," LSE Research Online Documents on Economics 51505, London School of Economics and Political Science, LSE Library.
  2. Enrique G. Mendoza, 2010. "Sudden Stops, Financial Crises, and Leverage," American Economic Review, American Economic Association, vol. 100(5), pages 1941-66, December.
  3. Philip R. Lane & Gian Maria Milesi-Ferretti, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities,1970–2004," The Institute for International Integration Studies Discussion Paper Series iiisdp126, IIIS.
  4. Jonathan David Ostry & Carmen Reinhart, 1991. "Private Saving and Terms of Trade Shocks; Evidence From Developing Countries," IMF Working Papers 91/100, International Monetary Fund.
  5. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  6. Guillermo A. Calvo & Alejandro Izquierdo & Luis Fernando Mejía, 2008. "Systemic Sudden Stops: The Relevance of Balance-Sheet Effects and Financial Integration," IDB Publications (Working Papers) 6747, Inter-American Development Bank.
  7. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 15114, University Library of Munich, Germany.
  8. 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).
  9. 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.
  10. 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.
  11. 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.
  12. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2011. "Financial Crises and Macro-Prudential Policies," IDB Publications (Working Papers) 27738, Inter-American Development Bank.
  13. Krusell, Per, 2002. "Time-consistent redistribution," European Economic Review, Elsevier, vol. 46(4-5), pages 755-769, May.
  14. repec:ner:tilbur:urn:nbn:nl:ui:12-3107633 is not listed on IDEAS
  15. 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.
  16. Timothy J. Kehoe & Kim J. Ruhl, 2007. "Are shocks to the terms of trade shocks to productivity?," Staff Report 391, Federal Reserve Bank of Minneapolis.
  17. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  18. 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.
  19. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  20. 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.
  21. Timothy J. Kehoe & Kim Ruhl, 2008. "Data Appendix to "Are Shocks to the Terms of Trade Shocks to Productivity?"," Technical Appendices 07-40, Review of Economic Dynamics.
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