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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. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  2. 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.
  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," IMF Working Papers 06/69, International Monetary Fund.
  4. 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.
  5. Reinhart, Carmen & Ostry, Jonathan, 1992. "Saving and Terms of Trade Shocks: Evidence from Developing Countries," MPRA Paper 6976, University Library of Munich, Germany.
  6. repec:ner:tilbur:urn:nbn:nl:ui:12-3107633 is not listed on IDEAS
  7. Javier Bianchi, 2011. "Overborrowing and Systemic Externalities in the Business Cycle," American Economic Review, American Economic Association, vol. 101(7), pages 3400-3426, December.
  8. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
  9. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric Young, 2011. "Financial Crises and Macro-Prudential Policies," Research Department Publications 4710, Inter-American Development Bank, Research Department.
  10. Enrique G. Mendoza, 2010. "Sudden Stops, Financial Crises, and Leverage," American Economic Review, American Economic Association, vol. 100(5), pages 1941-66, December.
  11. 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).
  12. 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.
  13. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 865-88, October.
  14. Krusell, Per, 2002. "Time-consistent redistribution," European Economic Review, Elsevier, vol. 46(4-5), pages 755-769, May.
  15. Olivier Jeanne & Romain Rancière, 2011. "The Optimal Level of International Reserves For Emerging Market Countries: A New Formula and Some Applications," Economic Journal, Royal Economic Society, vol. 121(555), pages 905-930, 09.
  16. 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.
  17. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  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. 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.
  20. 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.
  21. 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.
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