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Prudential policy with distorted beliefs

Author

Listed:
  • Dávila, Eduardo
  • Walther, Ansgar

Abstract

This paper studies leverage regulation and monetary policy when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal leverage regulation responds to arbitrary changes in investors’ and creditors’ beliefs and relate our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors and creditors, calls for tighter leverage regulation. Monetary policy should be tightened (loosened) in response to either investors’ or creditors’ optimism (pessimism). JEL Classification: G28, G21, E61, E52

Suggested Citation

  • Dávila, Eduardo & Walther, Ansgar, 2021. "Prudential policy with distorted beliefs," ESRB Working Paper Series 130, European Systemic Risk Board.
  • Handle: RePEc:srk:srkwps:2021130
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    References listed on IDEAS

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    Cited by:

    1. Haddad, Valentin & Ho, Paul & Loualiche, Erik, 2022. "Bubbles and the value of innovation," Journal of Financial Economics, Elsevier, vol. 145(1), pages 69-84.
    2. Hao Yang, 2022. "How Uncertainty About Market Crowdedness Impacts Asset Prices: Knight meets Vives," Working Papers hal-03686748, HAL.

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    More about this item

    Keywords

    bailouts; distorted beliefs; leverage regulation; monetary policy; prudential policy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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