Optimal Policy for Macro-Financial Stability

41 Pages Posted: 1 Feb 2013

See all articles by Gianluca Benigno

Gianluca Benigno

London School of Economics & Political Science (LSE) - Department of Economics

Huigang Chen

MarketShare Partners

Chris Otrok

University of Missouri; Federal Reserve Banks - Federal Reserve Bank of St. Louis

Alessandro Rebucci

Johns Hopkins University - Carey Business School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Eric R. Young

University of Virginia

Multiple version iconThere are 5 versions of this paper

Date Written: November 2012

Abstract

In this paper we study whether policy makers should wait to intervene until a financial crisis strikes or rather act in a preemptive manner. We study this question in a relatively simple dynamic stochastic general equilibrium model in which crises are endogenous events induced by the presence of an occasionally binding borrowing constraint as in Mendoza (2010). First, we show that the same set of taxes that replicates the constrained social planner allocation could be used optimally by a Ramsey planner to achieve the first best unconstrained equilibrium: in both cases without any precautionary intervention. Second, we show that the extent to which policymakers should intervene in a preemptive manner depends critically on the set of policy tools available and what these instruments can achieve when a crisis strikes. For example, in the context of our model, we find that, if the policy tools is constrained so that the first best cannot be achieved and the policy maker has access to only one tax instrument, it is always desirable to intervene before the crisis regardless of the instrument used. If however the policy maker has access to two instruments, it is optimal to act only during crisis times. Third and finally, we propose a computational algorithm to solve Markov-Perfect optimal policy for problems in which the policy function is not differentiable.

Keywords: Bailouts, Capital Controls, Exchange Rate Policy, Financial Crises, Financial Frictions, Macro-Financial Stability, Macro-Prudential Policies

JEL Classification: E52, F37, F41

Suggested Citation

Benigno, Gianluca and Chen, Huigang and Otrok, Christopher and Rebucci, Alessandro and Young, Eric R., Optimal Policy for Macro-Financial Stability (November 2012). CEPR Discussion Paper No. DP9223. Available at SSRN: https://ssrn.com/abstract=2210192

Gianluca Benigno (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

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Huigang Chen

MarketShare Partners ( email )

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Christopher Otrok

University of Missouri ( email )

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Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

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Alessandro Rebucci

Johns Hopkins University - Carey Business School ( email )

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HOME PAGE: http://carey.jhu.edu/faculty-research/faculty-directory/alessandro-rebucci-phd

National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Eric R. Young

University of Virginia ( email )

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Charlottesville, VA 22903
United States

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