Countercyclical capital regulation in a small open economy DSGE model

Abstract We examine, conditional on structural shocks, the macroeconomic performance of different countercyclical capital buffer (CCyB) rules in small open economy estimated medium-scale Dynamic Stochastic General Equilibrium (DSGE) model. We find that rules based on the credit gap create a trade-off between the stabilization of fluctuations originating in the housing market and fluctuations caused by foreign demand shocks. The trade-off disappears if the regulator responds to house prices instead. It turns out that the welfare-maximising simple CCyB rule implies responding to house prices only and not to the credit gap. Such rule also leads to significant welfare gains compared to the no CCyB case.