Overborrowing and Systemic Externalities in the Business Cycle Under Imperfect Information *

Abstract

We study the interaction between imperfect information and financial frictions and its role in financial crises in small open economies. We use a model where households observe income growth but do not perceive whether the underlying shocks are permanent or transitory, and borrowing is subject to a collateral constraint. We show that the combination of imperfect information and a borrowing constraint is a significant source of economic instability. The optimal macroprudential policy helps stabilize the economy by actively taxing debt, but its implementation is complex. The interaction between the collateral constraint and the information friction changes the cyclicality of the optimal tax. We show that a simple fixed-tax rule intervention is effective, and welfare benefits are close to the second-best.

Keywords: overborrowing, macroprudential policy, information frictions JEL classification: D62, D84, E44, F32, F38, F41

JEL Classification: D62, D84, E44, F32, F38, F41