Macroprudential Policy with Leakages

Abstract: We explore how imperfect regulation enforcement affects the design of optimal macroprudential policy. We study an open economy workhorse model of macroprudential regulation motivated by pecuniary externalities. Our analytical characterization shows that imperfect enforcement generates two opposing effects. While tighter regulation leads to higher borrowing by unregulated agents, a “leakage effect”, mitigating the increase in fragility calls for “squeezing” regulated agents further. Quantitative simulations show that, overall, a macroprudential policy that accounts for the leakages remains successful at mitigating the vulnerability to financial crises.