Optimal Policy for Macro-Financial Stability Gianluca Benigno 1 - - PowerPoint PPT Presentation

Optimal Policy for Macro-Financial Stability

Gianluca Benigno1 Huigang Chen2 Christopher Otrok3 Alessandro Rebucci4 Eric R. Young5

1LSE and Princeton 2MarketShare Partners 3University of Missouri and Federal Reserve Bank of St Louis 4Johns Hopkins University and IDB 5University of Virginia

2014 ASSA Meeting

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Introduction

Motivation

Global financial crisis proved very costly to resolve

Great recession in the US Near-death experience in Europe Strong and volatile capital flows in and out of emerging economies

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Introduction

Motivation

Debate on the role of policy for financial stability

Consensus before the crisis: intervene only during crises (e.g., Bailouts) Current view: intervene before crises (e.g., Macro-prudential policies)

Key questions:

When should policy makers intervene? Which policy tools should they use?

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Introduction

This paper

Develop a framework to study the optimal stabilization problem before AND during financial crises DSGE model with occasionally binding financial friction: the crisis event is endogenous and nested in a regular business cycle This requires the numerical solution of an optimal policy problem in which policy functions are not differentiable

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Introduction

Related literature

Literature on financial frictions Lorenzoni (2008), Bianchi (2011), Bianchi and Mendoza (2010), Jeanne and Korinek (2011) Chang, Cespedes and Velasco (2012), Benigno et al. (2012) Methodology: Klein, Krusell, and Rios-Rull (2009)

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Introduction

Framework

Focus on a simple model: Mendoza (2002)

Small open economy Two-goods that are consumed and produced A liquidity constraint that limits consumers’ borrowing to a fraction of their total income

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Introduction

Why is there scope for government intervention?

There is a pecuniary externality when the constraint binds:

Consumers do not take into account the effect of their choices on the price of collateral This affects their ability to borrow Which in turn affects the price of collateral And so and so forth ... Consumers and producers’ decisions can be affected by this externality even when the borrowing constraint is not binding

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Introduction

Main messages

Role and design of macroprudential policies depends on the effectiveness of crises management policy (interaction between ex ante and ex post policy interventions is crucial) When price support policies are costly or not effective, macroprudential becomes desirable (A new, intrinsic rationale for macroprudential policies) How credit is allocated matters as much as total size of credit flows

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Introduction

Outline

Simplified version of the model Key results Some evidence Conclusions

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Model

Preferences

Utility function: Uj ≡ E0

∞

∑

t=0

• βt log (Cj)
• ,

(1) Consumption basket and price index: Ct =

• C T

t

ω C N

t

1−ω ωω(1 − ω)1−ω (2) Pt =

• PN

t

1−ω . with PT

t = 1.

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Model

Constraints

Budget constraint: C T

t + PN t C N t + Bt+1 = Y T t + PN t Y N t + (1 + r) Bt,

(3) where Bt+1 denotes the bond holding at the end of period t, and 1 + r is a given world gross interest rate with β (1 + r) < 1. International Borrowing constraint: Bt+1 −1 − φ φ

• Y T

t + PN t Y N t

• .

(4) Crisis occurs when constraint binds endogenously.

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Model

Allocations

−1.1 −1 −0.9 −0.8 −0.7 −0.6 −2 −1.8 −1.6 −1.4 −1.2 −1 −0.8 −0.6

B(t) Debt

−1.1 −1 −0.9 −0.8 −0.7 −0.6 0.5 1 1.5 2

B(t) Tradable Consumption

−1.1 −1 −0.9 −0.8 −0.7 −0.6 1 2 3 4 5 6

B(t) Nontradable Price

CE SP UE BCORY Optimal Policy 2014 ASSA Meeting 12 / 51

Model

Government Policy

Three policy instruments:

Macroprudential tool (e.g., Capital control): τB

t

Price support tool (e.g., Real exchange rate targeting): τN

t or τT t

Balanced budget:

Non distortionary taxation Tt = τN

t PN t C N t

• r Tt = τB

t Bt+1

Distortionary taxation τB

t Bt+1 = τN t PN t C N t

Ramsey approach: maximizes agents’ utility subject to resource constraint, FOCs of competitive equilibrium, and government budget constraint conditional on policy tools available

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Key results

Comparing different tools

R1: Macroprudential (Capital control) with lump-sum transfers/taxes achieves SP (Korinek, 2010; Bianchi, 2011) R2: Price support (Real exchange rate) with lump-sum transfers/taxes achieves UE If costless, price support policy dominates macroprudential policy

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Key results

Mechanism

Relative price determination: PN

t

• 1 + τN

t

• = (1 − ω)
• C T

t

• ωC N

t

. (5) When the constraint does not bind τN

t is neutral (Euler equation and

resource constraint determines tradable consumption) When the constraint binds, τN

t can affect the price of collateral, and

hence the consumption of tradable goods

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Key results

Costly price support (Distortionary financing)

−1 −0.95 −0.9 −0.85 −0.8 −0.75 −0.7 −0.65 −0.6 −0.55 −0.5 −0.02 −0.01 0.01 0.02 0.03 0.04

Bt (τB

t ,τN t )

Taxes

τB

t

τN

t

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Key results

Competitive Equilibrium (CE) and Optimal Policy (OP)

−1.1 −1 −0.9 −0.8 −0.7 −0.6 −1.1 −1 −0.9 −0.8 −0.7 −0.6

Debt B(t)

−1.1 −1 −0.9 −0.8 −0.7 −0.6 0.2 0.4 0.6 0.8 1 1.2

B(t) Tradable Consumption

−1.1 −1 −0.9 −0.8 −0.7 −0.6 0.5 1 1.5 2 2.5 3

B(t) Nontradable Price

CE OP BCORY Optimal Policy 2014 ASSA Meeting 17 / 51

Key results

Welfare Gains and Crisis Probabilities

Ergodic Averages Debt to Income

• Prob. of Crisis

Welfare Gain CE −29.2% 6.7% NA SP −28.4% 1.2% 0.41% UE NA 0.0% 33.8% OP −30.5% 4.9% 1.10% Welfare gains from OP are quite large The economy with OP borrows more than the CE and macroprudential policies remain desirable

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Key results

Production

Production economy: the same externality has effect on consumption and production choices. Logic of the results extend to production economy: effectiveness of ex-post policies determine optimal design of ex ante policies Price support policies tend to dominate macro prudential policies

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Some evidence

What do countries do?

Consider Brazil and Mexico before and after Lehmann’s collapse: they had balance sheet mismatches in the corporate sector and used unconventional policy tools before and after the crisis

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Some evidence

Brazil and Mexico used a multiplicity of tools before and during crises

20 40 60 80 100 120 140

Nominal interest rate index (Sept 07=100) Brazil Mexico

Nominal Interest

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10

Real interest rate

Real Interest Rate

Brazil Mexico 80 85 90 95 100 105 Reserve requirements indedx (Jan 07=100) Brazil

Reserve Requirements

70 90 110 130 150 170 190 210 230 Reserves (Billions of Dollars)

Foreign Reserves

Brazil Mexico 60 70 80 90 100 110 120 130 Real exchange rate (Jan 2007=100)

Real Exchange Rate

Brazil Mexico 0.2 0.4 0.6 Brazil Mexico

Capital Controls Index

Outflows 2006 Inflows 2006 Inflows 2008 Outflows 2008

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Conclusions

Caveats and areas for future research

General results extends to cases when the constraint depends on asset prices or is forward looking Simple framework in which there is no policy trade off: with multiple distortions there is an intrinsic rationale for macroprudential policies even if price support is costless (e.g., price and financial stability)

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Conclusions

Conclusions

Study optimal stabilization policy in an environment in which financial crises are nested in regular cycles Role and design of macroprudential policies depends on the effectiveness of crisis management policies

When price support policies are costly, there is an intrinsic rationale for macropurdential policies

Where credit goes is as important as how much credit flows ...

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Conclusions

THANK YOU

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