Phases Of Global Liquidity, Fundamentals News, And The Design Of Macroprudential Policy by BIS
Minneapolis Fed, University of Wisconsin & NBER
Enrique G. Mendoza
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University of Pennsylvania, NBER & PIER
The unconventional shocks and non-linear dynamics behind the high volatility of financial markets present a challenge for the implementation of macroprudential policy. This paper introduces two of these unconventional shocks, news shocks about future fundamentals and regime changes in global liquidity, into a quantitative non-linear model of financial crises. The model is then used to examine how these shocks affect the design and effectiveness of optimal macroprudential policy. The results show that both shocks contribute to strengthen the amplification mechanism driving financial crisis dynamics. Macroprudential policy is effective for reducing the likelihood and magnitude of financial crises, but the optimal policy requires significant variation across regimes of global liquidity and realizations of news shocks. Moreover, the effectiveness of the policy improves as the precision of news rises from low levels, but at high levels of precision it becomes less effective (financial crises are less likely, but the optimal policy does not weaken them significantly).
Phases Of Global Liquidity, Fundamentals News, And The Design Of Macroprudential Policy – Introduction
There is wide consensus on the view that the goal of macroprudential policy is to hamper credit growth in periods of expansion in order to lower the frequency and magnitude of financial crises. There is much less agreement, however, on how to actually design and implement this policy. This is due in part to the lack of a well-established quantitative framework in which non-linear endogenous financial amplification mechanisms can produce infrequent financial crises with realistic features and nested within regular business cycles. Such a framework is a pre-requisite to build a platform that can be useful for evaluating the effectiveness of macroprudential policy tools.
One class of models that has made progress in this direction makes use of the Fisherian debt-deflation mechanism to amplify the effects of exogenous shocks in periods of financial distress, and thus generate nonlinear crisis dynamics. In models of this class, the market failure that justifies the use of macroprudential policy is a pecuniary externality that is ubiquitous in credit markets, because goods or assets used as collateral are valued at market prices: Private agents in a decentralized equilibrium do not internalize the large negative effects of individual borrowing decisions made in “good times” on collateral prices in “bad times,” when the debt-deflation mechanism induces large declines in relative prices. As a result, private agents borrow too much, relative to what is socially optimal, and leave the economy vulnerable to financial crises. Pecuniary externalities are typically harmless, but in these models they are not because collateral prices determine borrowing capacity and thus distort real allocations when credit constraints bind.
The literature on Fisherian models has shown that collateral constraints can produce substantial amplification and asymmetry in response to standard-size shocks hitting the typical driving forces of business cycles, such as TFP and terms-of-trade shocks (e.g. Mendoza (2010)), and it has also demonstrated how these models can be used to study the characteristics and effectiveness of various financial policies, including macroprudential policy.1 Despite this progress, however, most of the models developed to date study macroprudential policy assuming relatively simple structures of exogenous shocks and production technologies. Shocks usually affect TFP or interest rates following conventional, symmetric probabilistic processes known to agents.2 As a result, two key sources of financial volatility that deviate from this treatment, noisy news about future economic fundamentals and regime shifts in global liquidity, are still absent from the analysis of macroprudential policy. In contrast, empirical studies of credit cycles and financial crises suggest that factors like these are important determinants of credit dynamics and their interaction with the real economy (e.g., Calvo et al. (1996), Shin (2013), Bruno and Shin (2014), Mendoza and Terrones (2012), Borio (2013), Reinhart and Rogoff (2014), Schularick and Taylor (2009)).
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