Description

We study the interaction between imperfect information and financial frictions and its role in driving financial crises in small open economies. We use a model where households observe income growth but do not perceive whether the underlying shocks are permanent or transitory, and borrowing is subject to a collateral constraint. The optimal macroprudential policy helps stabilize the economy by actively taxing debt. We show that the combination of imperfect information and a borrowing constraint is a significant source of economic instability. The optimal tax under these conditions is six times larger than the tax in the perfect information limit.