Working Paper: CEPR ID: DP16197
Authors: Ansgar Walther; Eduardo Davila
Abstract: This paper studies leverage regulation and monetary policy when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal leverage regulation responds to arbitrary changes in investors' and creditors' beliefs and relate our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors and creditors, calls for tighter leverage regulation. Monetary policy should be tightened (loosened) in response to either investors' or creditors' optimism (pessimism).
Keywords: prudential policy; distorted beliefs; leverage regulation; bailouts; monetary policy
JEL Codes: G28; G21; E61; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimism among investors (G31) | looser leverage regulation (G18) |
| optimism among creditors (F34) | tighter leverage regulation (G18) |
| beliefs of investors and creditors (G32) | optimal regulatory response (G18) |
| belief states (D80) | monetary policy effectiveness (E52) |
| investor optimism (G31) | marginal value of leverage decreases (G32) |
| creditor optimism (F34) | marginal value of leverage increases (G32) |