Financial Cycles, Credit Bubbles and Stabilization Policies

44 Pages Posted: 21 Feb 2019

See all articles by Luisa Corrado

Luisa Corrado

University of Rome Tor Vergata Department of Economics and Finance

Tobias Schuler

CESifo (Center for Economic Studies and Ifo Institute) - Ifo Institute

Date Written: 2018

Abstract

This paper analyzes the effects of several policy instruments to mitigate financial bubbles generated in the banking sector. We augment a New Keynesian macroeconomic framework by endogenizing boundedly-rational expectations on asset values of loan portfolios and allow for interbank trading. We then show how a financial bubble can develop from a financial innovation. By incorporating a loan management technology and a bank equity channel we can evaluate the efficacy of several policy instruments in counteracting financial bubbles. We find that an endogenous capital requirement reduces the impact of a financial bubble significantly while central bank intervention (“leaning against the wind”) proves to be less effective. A welfare analysis ranks the policy reaction through an endogenous capital requirement as best.

Keywords: financial bubbles, credit-to-GDP gap, endogenous capital requirement, stabilization policies

JEL Classification: E440, E520

Suggested Citation

Corrado, Luisa and Schuler, Tobias, Financial Cycles, Credit Bubbles and Stabilization Policies (2018). CESifo Working Paper No. 7422. Available at SSRN: https://ssrn.com/abstract=3338776

Luisa Corrado (Contact Author)

University of Rome Tor Vergata Department of Economics and Finance ( email )

Via Columbia n.2
Rome, rome 00100
Italy

Tobias Schuler

CESifo (Center for Economic Studies and Ifo Institute) - Ifo Institute ( email )

Poschinger Str. 5
Munich, 01069
Germany

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