25.10.2022: Paul Fontanier – Optimal policy for behavioral financial crises

Presenter: Fontanier
Affiliation: Yale University, Yale School of Management

Paper: Optimal Policy for Behavioral Financial Crises

Date: October 25, 2022
Time: 12:00 GMT (15:00 Israel Time)

Abstract: Should policymakers adapt their macroprudential and monetary policies when the financial sector is vulnerable to belief-driven boom-bust cycles? I develop a model in which financial intermediaries are subject to collateral constraints, and that features a general class of deviations from rational expectations. I show that distinguishing between the drivers of behavioral biases matters: when biases are a function of equilibrium asset prices, new externalities arise, even in models that do not have any room for policy in their rational benchmark. I build on this theory to examine policy implications. First, the policymaker should use counter-cyclical capital buffers and time-varying loan-to-value ratios. These restrictions must be strengthened in times of over-optimism, as well as when the regulator is concerned that over-pessimism will arise in a future crisis. Second, uncertainty about the precise extent of behavioral biases in financial markets increases the incentives for the planner to act early. Finally, when biases depend on asset prices, monetary policy optimally complements macroprudential policy by leaning against the wind even when these macroprudential tools are unconstrained. Conventional monetary policy however loses power in normal times when agents expect the central bank to lean against the wind in the future.

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