Phases of global liquidity, fundamentals news, and the design of macroprudential policy

BIS Working Papers No 505
July 2015

This paper, which addresses a number of aspects of macroprudential policies, was produced as part of the BIS Consultative Council for the Americas Research Network project "Incorporating financial stability consideration into central bank policy models".

The unconventional shocks and non-linear dynamics behind the high volatility of financial markets present a challenge for the implementation of macroprudential policy. This paper introduces two of these unconventional shocks, news shocks about future fundamentals and regime changes in global liquidity, into a quantitative non-linear model of financial crises. The model is then used to examine how these shocks affect the design and effectiveness of optimal macroprudential policy. The results show that both shocks contribute to strengthen the amplification mechanism driving financial crisis dynamics. Macroprudential policy is effective for reducing the likelihood and magnitude of financial crises, but the optimal policy requires significant variation across regimes of global liquidity and realizations of news shocks. Moreover, the effectiveness of the policy improves as the precision of news rises from low levels, but at high levels of precision it becomes less effective (financial crises are less likely, but the optimal policy does not weaken them significantly).

JEL classification: D62, E32, E44, F32, F41

Keywords: financial crises, macroprudential policy, systemic risk, global liquidity, news shocks