Discussion Paper Details

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Title: Prudential Policy with Distorted Beliefs

Author(s): Eduardo Davila and Ansgar Walther

Publication Date: May 2021

Keyword(s): Bailouts, distorted beliefs, leverage regulation, monetary policy and Prudential policy

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

Abstract: This paper studies leverage regulation and monetary policy when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal leverage regulation responds to arbitrary changes in investors' and creditors' beliefs and relate our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors and creditors, calls for tighter leverage regulation. Monetary policy should be tightened (loosened) in response to either investors' or creditors' optimism (pessimism).

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Bibliographic Reference

Davila, E and Walther, A. 2021. 'Prudential Policy with Distorted Beliefs'. London, Centre for Economic Policy Research.