Financial Crises, Debt Volatility and Optimal Taxes

We study financial crises in a small open production economy subject to credit constraint and uncertainty on the value of debt repayments. We find that the possibility of reducing the severity of future crises encourages the central planner (CP) to increase both the crisis frequency and current debt. The CP equilibrium can be implemented by a macroprudential tax on debt and, only during crises, subsidies on consumption and a tax on non-tradable labor. The welfare gains of implementing such equilibrium is small for the baseline scenario but very sensitive to changes in debt volatility and the economy’s degree of openness.

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