Macroprudential Policies in the Presence of Pecuniary Externalities and Collateral Constraints in a Small Open Economy

The Global financial crisis of 2007-08 was preceded by global imbalances, or large capital account positions. The Great Recession that followed was caused by excessive external borrowing of debtor countries. In light of this, the question is whether policy is capable of preventing overborrowing or global imbalances. I show the answer to this depends crucially on the characterization of the underlying financial friction that caused the inefficient level of borrowing. The literature has focused attention on the borrowing constraints: market exclusion (Arellano (2008), Alvarez and Jermman (2000)), pecuniary cost of default (Goodhart, Peiris and Tsomocos (2016)), credit constraints (Jeanne and Korinek (2010), Bianchi and Mendoza (2013)) and collateral constraints (Cao (2017), Fostel and Geanokoplos (2008), Maffezzoli and Monacelli (2013). Market exclusion and the pecuniary externality of default deals with consequences in the event default occurs while the collateral and credit constraints focus attention on the mechanisms preventing defaults. The distinction between credit and collateral constraints lies in whether lenders are forward looking in enforcing a limit to the debt accumulated by borrowers. In practice both types of enforcement mechanisms are apparent. However, the implications for the path of the economic conditions and optimal policy that can prevent excessive external borrowing are different. I show that in the presence of credit constraints the economy becomes more sensitive to sudden stops events that lead to abrupt deleveraging and sharp fall in consumption. Furthermore, I show if credit constraints are the underlying friction in the economy then it is possible to reduce overborrowing by imposing a positive macroprudential tax while in the economy with the collateral constraint there is no policy that can resolve overborrowing.