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Macroprudential capital requirements, monetary policy, and financial crises

Johanna Krenz and Jelena Živanović

Economic Modelling, 2024, vol. 139, issue C

Abstract: How should bank capital requirements be designed in order to reduce the frequency and severity of financial crises? What is the role of monetary policy in this context? To answer these questions, we develop a New-Keynesian dynamic stochastic general equilibrium (DSGE) model in which the economy endogenously switches between normal times and financially turbulent times. Banks do not internalize that lower leverage contributes to the stability of the entire financial system. This creates a role for bank capital regulation. The proposed model replicates many of the dynamics observed during US financial crises. Basel-III-style capital buffers reduce the probability and length of financial crises while also reducing the size of the financial and non-financial sectors. Monetary policies that are more accommodative during financial crises can moderate economic downturns, thereby lowering the durations of financial distress. A combination of a small countercyclical capital buffer accompanied by a relief measure and an accommodative monetary policy during crises increases welfare.

Keywords: Endogenous regime-switching; Financial crisis; Financial frictions; Macroprudential policy; Capital buffers; Monetary policy (search for similar items in EconPapers)
JEL-codes: E12 E44 E52 G01 G21 G28 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:139:y:2024:i:c:s0264999324001809

DOI: 10.1016/j.econmod.2024.106823

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