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Optimal policy for macro-financial stability

Benigno, Gianluca and Chen, Huigang and Otrok, Chris and Rebucci, Alessandro and Young, Eric (2012) Optimal policy for macro-financial stability. CEP Discussion Papers, CEPDP1172. Centre for Economic Performance, London School of Economics and Political Science, London, UK.

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Identification Number: CEPDP1172

Abstract

In this paper we study whether policy makers should wait to intervene until a financial crisis strikes or rather act in a preemptive manner. We study this question in a relatively simple dynamic stochastic general equilibrium model in which crises are endogenous events induced by the presence of an occasionally binding borrowing constraint as in Mendoza (2010). First, we show that the same set of taxes that replicates the constrained social planner allocation could be used optimally by a Ramsey planner to achieve the first best unconstrained equilibrium: in both cases without any precautionary intervention. Second, we show that the extent to which policymakers should intervene in a preemptive manner depends critically on the set of policy tools available and what these instruments can achieve when a crisis strikes. For example, in the context of our model, we find that, if the policy tools is constrained so that the first best cannot be achieved and the policy make r has access to only one tax instrument, it is always desirable to intervene before the crisis regardless of the instrument used. If however the policy maker has access to two instruments, it is optimal to act only during crisis times. Third and finally, we propose a computational algorithm to solve Markov-Perfect optimal policy for problems in which the policy function is not differentiable.

Item Type: Monograph (Discussion Paper)
Official URL: http://cep.lse.ac.uk/_new/publications/series.asp?...
Additional Information: © 2012 The Authors
Subjects: H Social Sciences > HB Economic Theory
JEL classification: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects)
F - International Economics > F3 - International Finance > F37 - International Finance Forecasting and Simulation
F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics
Sets: Departments > Economics
Collections > Economists Online
Research centres and groups > Centre for Economic Performance (CEP)
Series: Working Papers > CEP Discussion Papers
Date Deposited: 07 Aug 2013 15:07
Last Modified: 07 Aug 2013 15:07
URI: http://eprints.lse.ac.uk/id/eprint/51519

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