Equilibrium Effects of Liquidity Constraints

Abstract

Investors do not internalize the interaction between debt accumulation and asset prices when they decide on their borrowing. This leads to credit expansions, which are mostly followed by a collapse in asset prices, so it amplifies booms and busts in the economy. This paper studies welfare analyses of the macroprudential policy that limits the borrowing capacity of investors by regulating the loan-to-value ratio of the asset. The results show that investors' borrowing capacity should be limited during booms when investors are overoptimistic, whereas it should not be limited during busts when they are overpessimistic. Overall, the optimal macroprudential policy on the loan-to-value ratio of the asset is countercyclical: letting investors borrow as much as they can during a recession and limiting the loan-to-value ratio of the asset during an expansion.

Keywords: Financial crisis, prudential regulation, Basel III, financial intermediaries

JEL Classification: G01, G21, G28