Prudential Policy with Debt Overhang
46 Pages Posted: 4 Mar 2021
Date Written: January 15, 2021
Abstract
Modern macroeconomy experienced recurrent financial crises followed by protracted periods of debt overhang and slow recovery. This paper proposes a tractable dynamic framework in which debt accumulated during credit booms is sufficiently large that corporate entities cannot attract voluntary new lending during a crisis. We study the efficiency properties and show that firms’ individually optimal investment decisions during credit booms fail to internalize their collective effect in exacerbating economy-wide debt overhang during recessions. Stabilization policies such as debt bailouts make the economy more crisis-prone, whereas market-based monetary stimulus discourages ex ante risk taking. Numerical illustrations suggest that optimally designed prudential policy substantially mitigates the incidence, severity, and protractedness of financial crises.
Keywords: financial crises, systemic risk, debt overhang, macroprudential regulation, debt bailouts, monetary stimulus
JEL Classification: E44, G18, H23
Suggested Citation: Suggested Citation