Working Paper: CEPR ID: DP8175
Authors: Gianluca Benigno; Huigang Chen; Christopher Otrok; Alessandro Rebucci; Eric R. Young
Abstract: Stochastic general equilibrium models of small open economies with occasionally binding financial frictions are capable of mimicking both the business cycles and the crisis events associated with the sudden stop in access to credit markets (Mendoza, 2010). In this paper we study the inefficiencies associated with borrowing decisions in a two-sector small open production economy. We find that this economy is much more likely to display "under-borrowing" rather than "over-borrowing" in normal times. As a result, macro-prudential policies (i.e. Tobin taxes or economy-wide controls on capital inflows) are costly in welfare terms in our economy. Moreover, we show that macro-prudential policies aimed at minimizing the probability of the crisis event might be welfare-reducing. Our analysis shows that there is a much larger scope for welfare gains from policy interventions during financial crises. That is to say that, within our modelling approach, ex post or crisis-management policies dominate ex ante or macro-prudential ones.
Keywords: bailouts; capital controls; crises; financial frictions; macroprudential policies; overborrowing
JEL Codes: E52; F37; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroprudential policies (E60) | welfare outcomes (I38) |
| financial frictions (G19) | underborrowing (G51) |
| underborrowing (G51) | policy interventions (D78) |
| macroprudential policies (E60) | lower average consumption levels (D12) |
| crisis events (H12) | welfare gains from bailouts (D69) |