Financial Crises and Macro-Prudential Policies
Paper No' CEPDP1032:
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Keywords: Capital controls; crises, financial frictions, macro prudential policies, bailouts,
JEL Classification: E52; F37; F41
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This Paper is published under the following series:
CEP Discussion Papers
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Stochastic general equilibrium models of small open economies with occasionally binding financial
frictions are capable of mimicking both the business cycles and the crisis events associated with the
sudden stop in access to credit markets (Mendoza, 2010). In this paper we study the inefficiencies
associated with borrowing decisions in a two-sector small open production economy. We find that this
economy is much more likely to display "under-borrowing" rather than "over-borrowing" in normal
times. As a result, macro-prudential policies (i.e. Tobin taxes or economy-wide controls on capital
inflows) are costly in welfare terms in our economy. Moreover, we show that macro-prudential
policies aimed at minimizing the probability of the crisis event might be welfare-reducing in
production economies. Our analysis shows that there is a much larger scope for welfare gains from
policy interventions during financial crises. That is to say that, within our modeling approach, ex post
or crisis-management policies dominate ex ante or macro-prudential ones.