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Optimal Policy for Macro-Financial Stability

Gianluca Benigno, Huigang Chen, Christopher Otrok (), Alessandro Rebucci () and Eric Young ()

CEP Discussion Papers from Centre for Economic Performance, LSE

Abstract: In this paper we study whether policy makers should wait to intervene until a financial crisis strikes or rather act in a preemptive manner. We study this question in a relatively simple dynamic stochastic general equilibrium model in which crises are endogenous events induced by the presence of an occasionally binding borrowing constraint as in Mendoza (2010). First, we show that the same set of taxes that replicates the constrained social planner allocation could be used optimally by a Ramsey planner to achieve the first best unconstrained equilibrium: in both cases without any precautionary intervention. Second, we show that the extent to which policymakers should intervene in a preemptive manner depends critically on the set of policy tools available and what these instruments can achieve when a crisis strikes. For example, in the context of our model, we find that, if the policy tools is constrained so that the first best cannot be achieved and the policy make r has access to only one tax instrument, it is always desirable to intervene before the crisis regardless of the instrument used. If however the policy maker has access to two instruments, it is optimal to act only during crisis times. Third and finally, we propose a computational algorithm to solve Markov-Perfect optimal policy for problems in which the policy function is not differentiable.

Keywords: Bailouts; capital controls; exchange rate policy; financial frictions; financial crises; macro-financial stability; macro-prudential policies (search for similar items in EconPapers)
JEL-codes: E52 F37 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Date: 2012-10
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http://cep.lse.ac.uk/pubs/download/dp1172.pdf (application/pdf)

Related works:
Working Paper: Optimal Policy for Macro-Financial Stability (2013)
Working Paper: Optimal Policy for Macro-Financial Stability (2012) Downloads
Working Paper: Optimal policy for macro-financial stability (2012) Downloads
Working Paper: Optimal policy for macro-financial stability (2012) Downloads
Working Paper: Optimal Policy for Macro-Financial Stability (2012) Downloads
Working Paper: Optimal Policy for Macro-Financial Stability (2012) Downloads
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