Countercyclical Capital Rules for Small Open Economies

51 Pages Posted: 19 Mar 2018

See all articles by Daragh Clancy

Daragh Clancy

European Stability Mechanism

Rossana Merola

International Labour Organization (ILO)

Date Written: March 9, 2016

Abstract

The growing literature on macroprudential regulation focuses on how a combination monetary and macroprudential policies can boost financial stability. We contribute to this literature by developing a DSGE model that assesses the effectiveness of countercyclical capital regulation in small open economies, in monetary unions or with exchange rate pegs, where policymakers do not have full control over traditional stabilisation instruments such as nominal interest and exchange rates. Our model shows that, in such economies, macroprudential policy must play an outsized role in mitigating the adverse effects of macro-financial feedback loops. To validate the model’s ability to replicate the stylised facts of financial crises, we calibrate using data for the Irish economy the recent housing crash. Our results demonstrate that the pro-active use of countercyclical capital regulation can indeed help ensure financial stability. In terms of policy advice, we find that bestowing even greater flexibility on regulators to act against the credit cycle has positive benefits. We also find that more aggressive action during the release phase can bolster the economy’s ability to absorb a negative shock.

Keywords: small open economy, macroprudential policy, macro-financial linkages

JEL Classification: E44, E51, G10, G28

Suggested Citation

Clancy, Daragh and Merola, Rossana, Countercyclical Capital Rules for Small Open Economies (March 9, 2016). European Stability Mechanism Working Paper No. 10; ISBN: 978-92-95085-10-7. Available at SSRN: https://ssrn.com/abstract=3143195 or http://dx.doi.org/10.2139/ssrn.3143195

Daragh Clancy (Contact Author)

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Rossana Merola

International Labour Organization (ILO) ( email )

Route des Morillons 4
Geneva, 1211
Switzerland

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