The Volatility Costs of Procyclical Lending Standards: An Assessment Using a DSGE Model

The ongoing financial turmoil has triggered a lively debate on ways of containing systemic risk and lessening the likelihood of future boom-and-bust episodes in credit markets. Particularly, it has been argued that banking regulation might attenuate procyclicality in lending standards by affecting the behavior of banks capital buffers. This paper uses a two-country DSGE model with financial frictions to illustrate how procyclicality in borrowing limits reinforces the ”overreaction” of asset prices to shocks described by Aiyagari and Gertler (1999), and to quantify the stabilization gains from policies aimed at smoothing cyclical swings in credit conditions. Results suggest that, in financially constrained economies, the ensuing volatility reduction in equity prices, investment, and external imbalances would be sizable. In the presence of cross-border spillovers, gains would be even higher.Credit Cycles; Collateral Constraints; DSGE Models

Regime Switching Interest Rates and Fluctuations in Emerging Markets

We estimate regime switching models for emerging market interest rates and embed the obtained nonlinear dynamics in a small open economy model with a financial friction. We show that the presence of an infrequent regime characterized by high level/high volatility of interest rates and the tightening of financial constraints is key to account for the empirical regularities specific to emerging markets, including the high volatility of consumption relative to output and a strongly countercyclical trade balance-to-output ratio. The model accounts for the dynamics of sudden stops and matches the autocorrelation function of the trade balance-to-output ratio as well as the cross-correlations between the main macroeconomic aggregates and interest rates. Our findings suggest that interest rate shocks and financial frictions are essential for explaining emerging market fluctuations, but mostly because of their effects in crisis episodes.regime switching model, peso problem, sudden stops, small open economy