Macroprudential policy in the presence of external risks

Ricardo Reyes-Heroles and Gabriel Tenorio

Journal of International Economics, 2020, vol. 126, issue C

Abstract: We document the relevance of external risks—shocks to the level and volatility of world interest rates—in shaping economic activity in emerging market economies (EMEs) and characterize optimal macroprudential policy in response to these risks in a small open economy subject to financial crises. Low and stable interest rates reinforce overborrowing arising from a pecuniary externality generated by collateral constraints that depend on asset prices. We show that this mechanism leads to greater exposure to crises typically accompanied by abrupt increases in interest rates and a persistent rise in their volatility, as observed during sudden stops in EMEs. A tax on international borrowing that implements a social planner's optimal policy can be decomposed into three factors: the severity of future crises, the ability of the planner to dampen future crises, and the incidence of future crises. We show that the effects of interest rate volatility on these factors implies that, qualitatively, the tax responds non-monotonically with respect to the direction of volatility shocks and that, quantitatively, increasing macroprudential taxes is seldom the optimal response to an increase in interest rate volatility.

Keywords: Macroprudential policy; Emerging market economies; Country-spreads; Time-varying volatility; Sudden stops; Financial crises (search for similar items in EconPapers)
JEL-codes: E6 F3 F4 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Working Paper: Macroprudential Policy in the Presence of External Risks (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:126:y:2020:i:c:s0022199618302915

DOI: 10.1016/j.jinteco.2020.103365

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