Financial Cycles, Credit Bubbles and Stabilization Policies
44 Pages Posted: 21 Feb 2019
Date Written: 2018
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: Suggested Citation