Optimal Policy in Collateral Constrained Economies
Posted: 7 Nov 2014 Last revised: 27 Jan 2016
Date Written: September 2015
This paper examines optimal policy in a macroeconomic model with collateral constraints. Binding collateral constraints yield inefficient competitive equilibrium allocations because they distort the optimal utilization of real resources. I identify the set of policy instruments that can be used by a Ramsey planner to achieve the first-best and the second-best (i.e. constrained planner's) allocations. A system of distortionary taxes on capital and labor income and lump-sum transfers among borrowers and lenders replicates the first-best outcome. I show analytically and numerically that the capital income tax is strictly positive in the long-run and it can be replaced by a tax on borrowing or by a loan-to-value limit, which underscores the necessity for financial regulation when the economy faces binding collateral requirements. In absence of lump-sum transfers, however, only second-best equilibrium outcomes are attainable. The Ramsey planner still sets positive capital income taxes or tightens loan-to-value ratios, but regulating labor is ambiguous since the policy instruments have the additional role of implementing implicit income transfers. I also derive the optimal policy in response to real and financial shocks, and show how the policy recommendations differ depending on the set of policy instruments available.
Keywords: Collateral constraints, Inefficiencies, Ramsey regulation, Welfare
JEL Classification: E60, H21, H23, H25
Suggested Citation: Suggested Citation