Overborrowing and systemic externalities in the business cycle under imperfect information

Juan Herreño and Carlos Rondón-Moreno

Journal of International Economics, 2025, vol. 157, issue C

Abstract: We study the interaction between imperfect information and financial frictions and their role in financial crises in small open economies. We use a model where households observe income growth but cannot distinguish whether the underlying income shocks are permanent or transitory, and borrowing is subject to a collateral constraint. We show that the combination of imperfect information and a borrowing constraint is a significant source of economic instability. Optimal macroprudential policy helps stabilize the economy by actively taxing debt. Furthermore, the interaction between the collateral constraint and the information friction reshapes the correlation between the optimal tax and the underlying components of income.

Keywords: Overborrowing; Macroprudential policy; Information frictions (search for similar items in EconPapers)
JEL-codes: D62 D84 E44 F32 F38 F41 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:157:y:2025:i:c:s0022199625000595

DOI: 10.1016/j.jinteco.2025.104103

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