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Foreign Capital Flows, Credit Growth and Macroprudential Policy in a DSGE Model with Traditional and Matter-of-Fact Financial Frictions

Fabia Carvalho () and Marcos Castro

No 387, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: We investigate the transmission channel of reserve requirements, capital requirements, and risk weights of different types of credit in the computation of capital adequacy ratios and compare the power of each macroprudential instrument to counteract the impact of domestic and international shocks that potentially challenge financial stability. To this end, we model a small open economy that receives inflows of foreign direct investment, foreign portfolio investment, and issues foreign debt. The central bank manages international reserves, with an impact on the foreign exchange market and on the country risk premium. Shocks in international markets affect domestic credit even though foreign capital flows are directly destined to non-financial institutions. Banks operate in four distinct credit markets: consumer, housing and commercial– each of them facing default risk and having specific borrowing constraints– and safe export-related credit lines in the form of working capital loans to exporters. Consumer loans are granted based on banks’ expectations with respect to borrowers’ future labor income net of senior debt services. Banks optimize their balance sheet allocation facing frictions intended to reproduce banks’ incentives given regulatory constraints. The model is estimated with Bayesian techniques using data from Brazil

Date: 2015-05
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge and nep-opm
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