Working Paper: NBER ID: w28879
Authors: Eduardo Dvila; Ansgar Walther
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: leverage regulation; monetary policy; distorted beliefs; financial stability
JEL Codes: E52; E61; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor optimism (G31) | Decrease in marginal value of leverage (G32) |
| Creditor optimism (F34) | Increase in marginal value of leverage (G32) |
| Creditor optimism (F34) | Tightening of leverage regulation (G18) |
| Investor optimism (G31) | Looser leverage regulation (G18) |
| Both investor and creditor optimism (G32) | Tightening of leverage regulation (G18) |