Working Paper: NBER ID: w22868
Authors: Enrique G. Mendoza
Abstract: Macroprudential policy holds the promise of becoming a powerful tool for preventing financial crises. Financial amplification in response to domestic shocks or global spillovers and pecuniary externalities caused by Fisherian collateral constraints provide a sound theoretical foundation for this policy. Quantitative studies show that models with these constraints replicate key stylized facts of financial crises, and that the optimal financial policy of an ideal constrained-efficient social planner reduces sharply the magnitude and frequency of crises. Research also shows, however, that implementing effective macroprudential policy still faces serious hurdles. This paper highlights three of them: (i) complexity, because the optimal policy responds widely and non-linearly to movements in both domestic factors and global spillovers due to regime shifts in global liquidity, news about global fundamentals, and recurrent innovation and regulatory changes in world markets, (ii) lack of credibility, because of time-inconsistency of the optimal policy under commitment, and (iii) coordination failure, because a careful balance with monetary policy is needed to avoid quantitatively large inefficiencies resulting from violations of Tinbergen’s rule or strategic interaction between monetary and financial authorities.
Keywords: Macroprudential Policy; Financial Crises; Collateral Constraints; Economic Models
JEL Codes: E44; E5; F34; F4; G01; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroprudential policy (E60) | severity and frequency of financial crises (G01) |
| complexity, lack of credibility, coordination failure (D73) | effective application of macroprudential measures (E61) |
| nonlinear responses of optimal policy to various shocks (C54) | complexity in macroprudential policy (E61) |
| lack of credibility (D83) | time-inconsistency issues in policy commitments (D15) |
| coordination between monetary and financial authorities (E61) | effectiveness of macroprudential interventions (E61) |
| financial amplification caused by collateral constraints (F65) | macroprudential policy effectiveness (E61) |