International coordination of macroprudential policies with capital flows and financial asymmetries

Abstract

Lack of coordination for prudential regulation hurts developing economies but benefits advanced economies. We consider a two-country macro model in which countries have limited ability to issue state-contingent contracts in international markets, and equilibrium is constrained inefficient. Both countries have incentives to stabilize their economy by using prudential limits, but the emerging economy depends on the advanced economy to bear global risk. Intermediating global risk requires bearing systemic risk, which financially developed economies are unwilling to bear, preferring financial stability over credit flows. Advanced economies prefer tighter prudential limits than would occur with coordination, to the harm of emerging economies.