Regulation and policy coordination in normal and crisis regimes

This work package is the first of three work packages that aim to develop new policy evaluation tools. Its focus is on the important issue of contagion between financial and real sectors within a single economy as well as international contagion from one economy to others. New regulatory and macro-prudential policy tools are evaluated while taking into account their interaction with monetary and fiscal policy. The work package partly builds on and refines modelling advances accomplished in the work packages on integrating more realistic financial institutions and market participants’ behaviour in policy-focused models. With the start of the financial crisis in 2007 risk spread across countries via the global financial system, as adverse shocks to the balance sheets of financial intermediaries in one country spilled over to financial intermediaries in other countries, causing further liquidity dry-ups and insolvencies. This experience suggests that cross-country policy coordination might have substantial gains in the internationally integrated environment where financial intermediation plays a role. As the financial crisis deepened into an international debt crisis, with particularly severe consequences in the euro area, contagion between private and public sector indebtedness moved to the forefront of the policy debate. Projects in the work package aim to deepen our understanding of the interaction of bank and financial institution balance sheets with the operation of stabilization and regulation policies in crisis and normal times. Special attention will be attributed to cross-country spill-overs in monetary unions and open economies). The role of tax payer support for banks and its impact on sovereigns are analyzed. Policy evaluation tools will be developed using models that endogenously generate shifts between normal and crisis regimes and to reproduce boom-and-bust cycles.

Key Objectives

(O.9.1) Further refine policy-focused models with financial sectors in order to evaluate the risk of contagion between the financial sector and other sectors as well as contagion between national economies. To investigate the impact of macro-prudential and regulatory measures and develop new policy evaluation tools based on such models.

(O.9.2) Study the interaction of bank balance sheets with stabilization and regulation policies with endogenously generated shifts between normal and crisis regimes and to explore the potential of policy rules and policy coordination to achieve welfare gains across various instruments and countries.

Main participants