Macropudential Policy in a Knightian Uncertainty Model with Credit-, Risk-, and Leverage Cycles

66 Pages Posted: 3 Oct 2015 Last revised: 26 Feb 2016

See all articles by Eddie Gerba

Eddie Gerba

Banco de España; London School of Economics & Political Science (LSE); CES Ifo Institute; European Central Bank

Dawid Żochowski

European Central Bank

Date Written: August 27, 2015

Abstract

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

Gerba, Eddie and Żochowski, Dawid, Macropudential Policy in a Knightian Uncertainty Model with Credit-, Risk-, and Leverage Cycles (August 27, 2015). Available at SSRN: https://ssrn.com/abstract=2645656 or http://dx.doi.org/10.2139/ssrn.2645656

Eddie Gerba (Contact Author)

Banco de España ( email )

Alcala 50
Madrid 28014
Spain
(+34)917088132 (Phone)

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

Houghton Street
London WC2A 2AE
United Kingdom

CES Ifo Institute ( email )

Poschinger Str. 5
Munich, 01069
Germany

European Central Bank ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Dawid Żochowski

European Central Bank ( email )

Sonnemannstrasse 20
Frankfurt am Main, 60314
Germany

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