A Model of Macroprudential Frictions for Indirect Monetary Policy in The Bahamas

The paper proposes a dynamic stochastic general equilibrium (DSGE) model of indirect monetary policy for The Bahamas. The model consists of ‘macroprudential frictions’ including a financial accelerator mechanism for the contract between entrepreneurs and financial intermediaries; a borrowing constraint for the contract between credit-constrained households and financial intermediaries; and ‘distance-to-default’ as a proxy for financial intermediaries’ balance sheet strength. The data used to estimate the model are a mix of U.S. data—a proxy for financial-sector shocks—and Bahamian macro aggregates. The results show that macroprudential shocks are substantial drivers of welfare during recessions, while standard productivity, monetary policy, and investment-specific shocks drive welfare outside of recessions. Housing price dynamics, banking sector risk premiums, and discount factor shocks account for most of the variance in the output and consumption decompositions. Comparing the model to one without macroprudential frictions reveals that ignoring relevant policy specifications leads to significant ‘policy mistakes