Working Paper: CEPR ID: DP9223
Authors: Gianluca Benigno; Huigang Chen; Christopher Otrok; Alessandro Rebucci; Eric R. Young
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 maker 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 crises; financial frictions; macro-financial stability; macroprudential policies
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 |
|---|---|
| Effectiveness of policy tools (F68) | Need for preemptive intervention (H84) |
| One tax instrument (H20) | Always optimal to intervene before a crisis (H12) |
| Two tax instruments (H29) | Optimal to act only during crisis times (H12) |
| Optimal design of preemptive interventions (C41) | Contingent on effectiveness of policy tools during crises (H12) |
| Optimal policies in dynamic settings (C61) | Significant advancement in analysis of macro-financial stability (E44) |