In this paper, we use a DSGE model to study the passive and time-varying implementation of macroprudential policy when policymakers have noisy and lagged data, as commonly observed in low income and developing countries (LIDCs). The model features an economy with two agents; households and entrepreneurs. Entrepreneurs are the borrowers in this economy and need capital as collateral to obtain loans. The macroprudential regulator uses the collateral requirement as the policy instrument. In this set-up, we compare policy performances of permanently increasing the collateral requirement (passive policy) versus a time-varying (active) policy which responds to credit developments. Results show that with perfect and timely information, an active approach is welfare superior, since it is more effective in providing financial stability with no long-run output cost. If the policymaker is not able to observe the economic conditions perfectly or observe with a lag, a cautious (less aggressive) policy or even a passive approach may be preferred. However, the latter comes at the expense of increasing inequality and a long-run output cost. The results therefore point to the need for a more careful consideration toward the passive policy, which is usually advocated for LIDCs.

The recent financial crisis has emphasized that there is the need for policies that enhance the stability of the financial system, namely macroprudential policies. However, the policy agenda is still very much evolving and there is scarce evidence on the implementation of these policies around the globe, especially for low-income and developing countries (LIDCs).1 Hence there is a need to build theoretical frameworks that may help countries undertake these policies in the most effective manner. There are several ways macroprudential instruments could be designed and implemented, with important implications for the financial system and the overall economy. At least, it has to be taken into account that macroprudential policy has both benefits as well as costs. The benefits, when tools are used effectively, include a more stable financial system, which in principle reduces the probability of a crisis and its impact when/if it happens. However, these tools could have other economic implications as they could restrict credit and financial access more broadly; and could bring short and long-run output costs.