This paper evaluates the monetary and macroprudential policies that mitigate the procyclicality arising from the interlinkages between current account deficits and financial vulnerabilities. We develop a two-country dynamic stochastic general equilibrium (DSGE) model with heterogeneous households and collateralised debt. The model predicts that external shocks are important in driving current account deficits that are coupled with run-ups in house prices and household debt. In this context, optimal policy features an interest-rate response to credit and a LTV ratio that countercyclically responds to house price dynamics. By allowing an interest-rate response to changes in financial variables, the monetary policy authority improves social welfare, because of the large welfare gains accrued to the Savers. The additional use of a countercyclical LTV ratio that responds to house prices, increases the ability of borrowers to smooth consumption over the cycle and is Pareto improving. Domestic and foreign shocks account for a similar fraction of the welfare gains delivered by such a policy.

This article highlights a novel channel through which the level of deposits matters for bank fragility and efficiency. We augment a global-game model of bank runs with a consumption-saving choice that determines deposit size in the initial period. We derive two key results. First, depositors’ incentives to run increase with the amount of savings held as bank deposits. Second, a saving externality emerges because individual depositors fail to internalize the impact of their deposit decisions on the likelihood of a bank run. This leads to depositors’ over-saving and inefficient bank liquidity provision, as well as excessive bank fragility. Finally, we characterize the optimal policy to implement the efficient allocation.

We examine optimal capital requirements in a quantitative general equilibrium model with banks exposed to nondiversifiable borrower default risk. Contrary to standard models of bank default risk, our framework captures the limited upside, but significant downside risk of loan portfolio returns. This helps to reproduce the frequency and severity of twin defaults : simultaneously high firm and bank defaults. Hence, the optimal bank capital requirement, which trades off a lower frequency of twin defaults against restricting credit provision, is higher than under default risk models which underestimate the impact of borrower default on bank solvency.

Using a vector-autoregression (VAR) model and data from the University of Michigan Survey of Consumers, we provide evidence on the importance of news and consumers’ beliefs for housing-market dynamics and aggregate fluctuations. We document that innovations to News on Business Conditions generate hump-shaped responses in house prices and other macroeconomic variables. We also show that innovations to Expectations of Rising House Prices are particularly important in explaining the path of macroeconomic variables during housing booms. To disentangle the effects of News on Business Conditions from other sources of expectation-driven cycles, we estimate a VAR where the News variable is ordered first. Innovations to News on Business Conditions generate Expectations of Rising House Prices. However, during housing booms, innovations to Expectations of Rising House Prices unrelated to News on Business Conditions account for a large part of macroeconomic fluctuations. Shocks to News and Expectations account together for more than half of the forecast error variance of house prices, and other macroeconomic variables, during periods of booms in house prices.

We show that lender of last resort (LOLR) policy exacerbates bank interconnectedness. Using novel micro-level data, we analyze LOLR’s haircut gaps: the differences between the private market and central bank haircuts. LOLR policy incentivizes banks to increase pledging and holdings of higher haircut-gap bonds, especially those issued by domestic and systemically important banks. Effects only apply to banks, not to nonbanks without LOLR access. LOLR funding revives bank bond issuance associated with higher haircut gaps and increases the subsequent correlation between pledging and issuing banks’ bond prices, in particular during periods of low-market returns and for domestic, systemically important banks.