Macroprudential Policy, Incomplete Information and Inequality: The case of Low-Income and Developing Countries

IMF Working Papers, March 22, 2017

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Paper uses a DSGE model to study passive and time-varying implementation of macroprudential policy under noisy and lagged data, characteristic of low-income and developing countries (LIDCs).
Economy features two agents: households and entrepreneurs.
Entrepreneurs are borrowers and require capital as collateral to obtain loans.
Macroprudential regulator uses the collateral requirement as the policy instrument.
Comparative policy experiments: permanently increasing the collateral requirement (passive policy) versus a time-varying (active) policy responding to credit developments.

With perfect and timely information:
- An active (time-varying) approach is welfare superior.
- Active policy is more effective in providing financial stability with no long-run output cost.
With noisy or lagged information:
- A cautious (less aggressive) policy or even a passive approach may be preferred by the policymaker.
- Passive or overly cautious approaches come at the expense of increasing inequality and a long-run output cost.
Conclusion: Results point to the need for more careful consideration of passive policies, which are usually advocated for LIDCs.

Favor active, time-varying macroprudential responses when policymakers can obtain sufficiently accurate and timely information.
When information is noisy or lagged, weigh the trade-offs: less aggressive or passive collateral requirements may reduce immediate policy mistakes but increase inequality and impose long-run output costs.
LIDCs that typically advocate passive macroprudential stances should reassess the distributional and long-term output implications of such policies given informational constraints.