Macroprudential regulation and macroeconomic activity

• This paper studies macroprudential regulation in a DSGE model.
• Features asymmetries, pecuniary externalities and the financial accelerator mechanism.
• It shows that higher bank capital requirements reduce volatility and raise welfare.
• Countercyclical capital requirements also reduce volatility and raise welfare.
• Solves for the optimal level of capital requirements.

I develop a dynamic stochastic general equilibrium model to examine the impact of macroprudential regulation on banks’ financial decisions and the implications for the real sector. I model an occasionally binding capital requirement constraint and analyze its costs and benefits. This friction means that the banks refrain from valuable lending. At the same time, capital requirements provide structural stability to the financial system. I show that higher capital requirements can dampen the business cycle fluctuations and raise welfare. I also show that switching to a countercyclical capital requirement regime can help reduce volatility and raise welfare. Finally, by means of the welfare analysis, I also obtain the optimal level of capital requirement.