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Abstract:

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CEP Discussion Paper
Financial Crises and Macro-Prudential Policies
Gianluca Benigno, Huigang Chen, Christopher Otrok, Alessandro Rebucci and Eric R. Young December 2010
Paper No' CEPDP1032:
Full Paper (pdf)

JEL Classification: E52; F37; F41


Tags: capital controls; crises; financial frictions; macro prudential policies; bailouts; overborrowing

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 in production economies. 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 modeling approach, ex post or crisis-management policies dominate ex ante or macro-prudential ones.