Macroprudential policy and foreign interest rate shocks: A comparison of different instruments and regulatory regimes

Stellenbosch Working Paper Series No. WP15/2017
 
Publication date: December 2017
 
Author(s):
[protected email address] (Department of Economics, University of Stellenbosch)
[protected email address] (Department of Economics, University of Stellenbosch)
 
Abstract:

This paper presents a generic small open economy real business cycle model with banking and foreign borrowing. We incorporate capital requirements, reserve requirements, and loan-to-value (LTV) regulation into this framework, and subject the model to a positive foreign interest rate shock that raises the country risk premium and reduces the supply of foreign funds. The results show that these macroprudential instruments can attenuate the impact of such a shock, and that this attenuation property increases with the strictness of the regulatory regime. Capital requirements and LTV regulation deliver the largest attenuation benefits and are shown to be close substitutes. That being said, capital requirements are shown to be more effective at leaning against the financial cycle whereas LTV regulation is more effective at stimulating the financial cycle. The analysis indicates that capital and reserve requirements can interact such that reserve requirements are most effective when used to supplement existing capital requirement or LTV measures. We find that financial and macroeconomic stability objectives are aligned following a positive foreign interest rate shock such that a macroprudential response to such shocks can be to the benefit of both objectives. Lastly, our results show that capital requirements and LTV regulation exhibit decreasing returns to scale.

 
JEL Classification:

E32, E44, E58, F38, F41, G28

Keywords:

Macroprudential policy, Open economy macroeconomics, Financial stability, Business cycle, Welfare, DSGE

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BER Weekly

6 July 2020
The main domestic data event over the past week was the release of the 2020Q1 GDP figures. Although not as poor as feared, the data still highlighted just how weak the SA economy was even before the unprecedented COVID-19 crisis hit with full force in 2020Q2. In other domestic news, a heated debate is raging about the fiscal consolidation outlined in...

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