A0480
Title: Countercyclical capital rules for small open economies
Authors: Rossana Merola - ILO International Labour Office (Switzerland) [presenting]
Daragh Clancy - ESM European Stability Mechanism (Luxembourg)
Abstract: Macro-financial feedback loops played a key role in both triggering and propagating the recent financial crisis. The Great Recession proved that macroeconomic policies were insufficient to ensure financial stability. This has been particularly true for small open economies within a monetary union, as they are constrained in the use of traditional stabilisation tools, such as nominal interest and exchange rates. We develop a DSGE model with a banking sector tailored for a small open economy in a monetary union. In our model, loans defaults are related to the value of collateralized assets (i.e. housing) and to wage income. We find that positive expectations for future house prices play a role in the accumulation of credit risk. The negative effects of this over extension of credit materialise when the bubble busts and these expectations prove to be overoptimistic. The resulting slowdown in economic activity, lower disposable incomes and a greater risk of unemployment, combined with devalued collateral, further exacerbate the increase in non-performing loans bank losses. In terms of policy advice, our simulations suggest that a proactive macro prudential rule responding to credit growth can help in smoothing economic fluctuations and promoting financial and macroeconomic stability. We also find that more aggressive action during the release phase can bolster the economy's ability to absorb a negative financial shock and damper its effects on the labour market.
