From Emmanuel Farhi and Iván Werning,
We provide a unifying foundation for macroprudential policies in financial markets for economies with nominal rigidities in goods and labor markets. Interventions are beneficial because of an aggregate demand externality. Ex post, the distribution of wealth across agents affect aggregate demand and the efficiency of equilibrium through Keynesian channels. However, ex ante, these effects are not privately internalized in the financial decisions agents make. We obtain a formula that characterizes the size and direction for optimal financial market interventions. We provide a number of applications of our general theory, including macroprudential policies guarding against deleveraging and liquidity traps, capital controls due to fixed exchange rates or liquidity traps and fiscal transfers within a currency union. Finally, we show how our results are also relevant for redistributive or social insurance policies, such as income taxes or unemployment benefits, allowing one to incorporate the macroeconomic benefits associated with these policies.
We have proposed new theoretical foundations for macroprudential regulation. Our theory introduces two key frictions in the Arrow-Debreu model, nominal rigidities in goods and labor markets, and constraints on monetary policy such as the zero lower bound or fixed exchange rates. We have shown that in general, competitive equilibria are constrained inefficient. The market failure is imputable to aggregate demand externalities. Government intervention in financial markets in the form of financial taxes or quantity restrictions can generate Pareto improvements. We have given simple and interpretable formulas for optimal interventions. We have also provided a number of concrete and relevant applications. And finally we have shown that these insights are also important to appropriately take into account the macroeconomic stabilization benefits of redistribution policies.