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Sudden Floods, Macroprudential 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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Paper provided by Economics, The Univeristy of Manchester in its series Centre for Growth and Business Cycle Research Discussion Paper Series with number 166.

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Length: 55 pages
Date of creation: 2012
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Handle: RePEc:man:cgbcrp:166
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