Sudden floods, macroprudential regulation and stability in an open economy ¬リニ

A dynamic stochastic model of a small open economy with a twolevel banking intermediation structure, a risk-sensitive regulatory capital regime, and imperfect capital mobility is developed. Firms borrow from a domestic bank and the bank borrows on world capital markets, in both cases subject to a premium. A sudden flood in capital flows generates an expansion in credit and activity, as well as asset price pressures. Countercyclical capital regulation, in the form of a Basel III-type rule based on credit gaps, is effective at promoting macro stability (defined in terms of the volatility of a weighted average of inflation and output deviations) and financial stability (defined in terms of three measures based on asset prices, the credit-to-GDP ratio, and the ratio of bank foreign borrowing to GDP). However, because the gain in terms of reduced economic volatility exhibits diminishing returns, in practice a countercyclical regulatory capital rule may need to be supplemented by other, more targeted macroprudential instruments when shocks are large and persistent. © 2014 Elsevier Ltd. All rights reserved. * We are grateful to an anonymous referee and participants at the G20 Seminar in Rio de Janeiro, the Inter-American Development Bank Seminar for Central Banks and Ministries of Finance, and at seminars at the Central Bank of Brazil and the European Central Bank, for helpful comments and discussions. Appendices A and B are available upon request. The views expressed in this paper are our own. * Corresponding author. E-mail address: [email protected] (P.-R. Ag enor).