Optimal Policy for Macro-Financial Stability

By Gianluca Benigno, Huigang Chen, Chris Otrok, Alessandro Rebucci and Eric Young


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 maker 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.

Interesting paper on the question whether policy should be proactive or reactive with respect to financial crises. What I find particularly interesting is that a well-tooled policy-maker should rather be reactive, which I find counter-intuitive. The reason is somewhat difficult to explain in a few words: During a crisis, two instruments allow to intervene with one and undo detrimental distortions from the first with the second. If there is only one instrument, it is best not to intervene during the crisis, as the distortion cannot be undone, but one can act preemptively.


One Response to Optimal Policy for Macro-Financial Stability

  1. Alessandro Rebucci says:

    The result is fairly intuitive. Consider ongoing efforts by the Fed to support the economy with exceptionally low interest rates and other quantitative easing measures. We know that low interest rates might lead to increased financial instability via several mechanisms, and possibly a follow up financial debacle once we exit from the current period of subdued economic activity. But the fed can temper these side effects by using a second se of tools, e.g., regulatory measures, to contain such distortions, and hence be very aggressive with its stimulative measures at this critical juncture. If instead there were no additional tools to complement the ongoing crisis response, the Fed would probably have to be much more cautious in using its crisis resolution tools, and would have no choice other than trying to prevent the next crisis from occurring with tightening of monetary policy in a preventive manner. Our research shows that this second, alternative course of policy action is dominated in welfare tems by the former.

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