This paper presents a new version of MAPMOD (Mark II) to study the effectiveness of macroprudential regulations. We extend the original model by explicitly modeling the housing market. We show how household demand for housing, house prices, and bank mortgages are intertwined in what we call a deadly embrace. Without macroprudential policies, this deadly embrace naturally leads to housing boom and bust cycles, which can be very costly for the economy, as shown by the Global Financial Crisis of 2008-09.

This paper assesses the effectiveness of countercyclical buffers (CCBs) and loan-to-value (LTV) limits for mitigating the risk and costs of financial crises. For this purpose, we use a version of the MAPMOD model augmented by an explicit housing sector. 1 MAPMOD departs from the traditional loanable funds model. It assumes that bank lending is not constrained by loanable funds, but by the banks’ own expectations about future profitability and banking regulations. In MAPMOD, the banking system may create purchasing power and facilitate efficient resource allocation when there are permanent improvements in the economy’s growth potential. However, the possibility of excessively large and risky loans, not justified by growth prospects, also exists. 2These risky loans can ultimately impair bank balance sheets and sow the seeds of a financial crisis. Banks respond to losses through higher spreads and sharp credit cutbacks, with adverse effects for the real economy. These features of MAPMOD capture key facts of financial cycles, like the correlations of bank credit with the business cycle and with asset prices (Brei and Gambacorta, 2014; Mendoza, 2010; Mian and Sufi, 2010; and Wong, 2012).