Financial stability, growth and macroprudential policy

Abstract

This paper studies the effect of optimal macroprudential policy in a small open economy model where growth is endogenous. By introducing endogenous growth, this model is able to capture the persistent effect of financial crises on output, which is different from previous literature but consistent with the data. Furthermore, there is a new policy trade-off between cyclical and trend consumption growth. In a calibrated version of the baseline model, I find that the impact of the optimal macroprudential policy on growth and welfare is quantitatively small even if it significantly increases financial stability. I consider two extensions of the model in which the optimal macroprudential policy has a larger impact on growth and welfare: one in which macroprudential policy is jointly used with a growth subsidy that helps reduce the cost of financial crises; and another extension with a direct growth externality.