The seminar will be held in the Visitor Centre at 15:15
Gianluca Benigno (LSE and New York Fed)
Abstract
We study optimal stabilization policy in a small-open economy in which a foreign borrowing constraint binds only occasionally. The objective of the paper is to determine the extent to which the optimal policy should have a precautionary component to it. That is, should the government intervene before the constraint actually binds? In the model, the policy instrument of the government is a distortionary tax wedge on consumption of non-tradable goods that affects the real price on nontradable goods, which is akin to an intervention on the real exchange rate. We find that the optimal policy is highly nonlinear. If the constraint is not binding, the optimal tax rate is zero, as in an economy without any credit constraint. Therefore there is no precautionary component to policy in this basic set up. If the constraint is binding, the optimal policy requires to intervene aggressively and, under plausible parameter assumptions, to intervene by subsidizing the consumption of non-tradable goods. The welfare gains associated with such a policy are significant, and come about by inducing lower self-insurance on the part of the private sector.