Financial Cycles, Credit Bubbles and Stabilization Policies
44 Pages Posted: 4 Dec 2019
Date Written: December, 2019
This paper analyzes the effects of several policy instruments for mitigating 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, allow for interbank trading and show how a credit bubble can develop from a financial innovation. We then 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 highest. We therefore provide a rationale for the use of countercyclical capital buffers.
Keywords: Basel III, CCyB, credit-to-GDP gap
JEL Classification: E44, E52
Suggested Citation: Suggested Citation