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Countercyclical capital rules for small open economies

Daragh Clancy and Rossana Merola

Working Papers from European Stability Mechanism

Abstract: The growing literature on macroprudential regulation focuses on how a combination monetary and macroprudential policies can boost financial stability. We contribute to this literature by developing a DSGE model that assesses the effectiveness of countercyclical capital regulation in small open economies, in monetary unions or with exchange rate pegs, where policymakers do not have full control over traditional stabilisation instruments such as nominal interest and exchange rates. Our model shows that, in such economies, macroprudential policy must play an outsized role in mitigating the adverse effects of macro-financial feedback loops. To validate the model’s ability to replicate the stylised facts of financial crises, we calibrate using data for the Irish economy the recent housing crash. Our results demonstrate that the pro-active use of countercyclical capital regulation can indeed help ensure financial stability. In terms of policy advice, we find that bestowing even greater flexibility on regulators to act against the credit cycle has positive benefits. We also find that more aggressive action during the release phase can bolster the economy’s ability to absorb a negative shock.

Keywords: small open economy; macroprudential policy; macro-financial linkages (search for similar items in EconPapers)
JEL-codes: E44 E51 G10 G28 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2016-05-02
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7) Track citations by RSS feed


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