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Countercyclical capital rules for small open economies

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  • Daragh Clancy

    (ESM)

  • Rossana Merola

    (International Labour Organisation)

Abstract

The growing literature on macroprudential regulation focuses on how a combination monetary and macroprudential policies can boost financial stability. We contribute to this literature by developing a DSGE model that assesses the effectiveness of countercyclical capital regulation in small open economies, in monetary unions or with exchange rate pegs, where policymakers do not have full control over traditional stabilisation instruments such as nominal interest and exchange rates. Our model shows that, in such economies, macroprudential policy must play an outsized role in mitigating the adverse effects of macro-financial feedback loops. To validate the model’s ability to replicate the stylised facts of financial crises, we calibrate using data for the Irish economy the recent housing crash. Our results demonstrate that the pro-active use of countercyclical capital regulation can indeed help ensure financial stability. In terms of policy advice, we find that bestowing even greater flexibility on regulators to act against the credit cycle has positive benefits. We also find that more aggressive action during the release phase can bolster the economy’s ability to absorb a negative shock.

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  • Daragh Clancy & Rossana Merola, 2016. "Countercyclical capital rules for small open economies," Working Papers 10, European Stability Mechanism.
  • Handle: RePEc:stm:wpaper:10
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    4. Jakab, Zoltan & Kumhof, Michael, 2018. "Banks are not intermediaries of loanable funds — facts, theory and evidence," Bank of England working papers 761, Bank of England, revised 17 Jan 2020.
    5. Luca Onorante & Matija Lozej & Ansgar Rannenberg, 2017. "Countercyclical capital regulation in a small open economy DSGE model," IFC Bulletins chapters, in: Bank for International Settlements (ed.), Data needs and Statistics compilation for macroprudential analysis, volume 46, Bank for International Settlements.
    6. Kumhof, Michael & Wang, Xuan, 2018. "Banks, money and the zero lower bound on deposit rates," Bank of England working papers 752, Bank of England, revised 19 Nov 2020.
    7. McQuinn, Kieran & Varthalitis, Petros, 2018. "How openness to trade rescued the Irish economy," Papers WP608, Economic and Social Research Institute (ESRI).
    8. Pierre-Richard Agénor & Timothy P. Jackson & Luiz Pereira da Silva, 2020. "Cross-Border Regulatory Spillovers and Macroprudential Policy Coordination," Working Papers 202028, University of Liverpool, Department of Economics.
    9. Petra Gerlach-Kristen & Rossana Merola, 2019. "Consumption and credit constraints: a model and evidence from Ireland," Empirical Economics, Springer, vol. 57(2), pages 475-503, August.
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    More about this item

    Keywords

    small open economy; macroprudential policy; macro-financial linkages;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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