Macropudential Policy in a Knightian Uncertainty Model with Credit-, Risk-, and Leverage Cycles
66 Pages Posted: 3 Oct 2015 Last revised: 26 Feb 2016
Date Written: August 27, 2015
We attempt to explain two stylized facts of the Great Recession, namely the build-up of high leverage in the household sector in the boom phase, deep busts and protracted recovery as rare systemic events. We extend Boz and Mendoza (2014) by explicitly modeling the credit markets and modifying the learning to an adaptive set-up. We find that in such a set-up, the build-up of leverage and the collateral price cycles take longer than in other DSGE models with financial frictions. The boom-bust cycles occur as rare events, with two systemic crises per century. The model also replicates asymmetric distributions of key macroeconomic and financial variables, with high skewness and fat tails. In addition, we show that a simple LTV-cap regulation is effective in smoothing the leverage cycles by limiting household borrowing in upturns, both via quantity (higher equity participation requirement) and price (lower collateral value) effects, as well as providing a well defined anchor for the agents in their learning process.
Keywords: Uncertainty, financial engeneering, deregulation, leverage forecasting, macroprudential policy
JEL Classification: G14, G17, G21, G32, E44, E58
Suggested Citation: Suggested Citation