Working paper 719
International Review of Economics and Finance
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 may exhibit decreasing returns to scale.
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