Essays on macro-prudential policies in economies with incomplete markets and collateral constraints

The 2008-09 Global Financial Crisis (GFC) reminds us that unregulated financial markets increase default risk and pose threats to the real economy. This drew attention to macro-prudential policies which mostly restrict the trading of financial assets. However, they ignore that these macro-prudential policies may raise borrowing and lending barriers, resulting in a decline in social welfare. As the excessive leverage and the sharp drops in asset prices are blamed for the trigger of GFC, this thesis specifies the barriers as collateral constraints that connects the borrowing capacity with asset prices. In the first and second papers, macro-prudential policies tighten collateral constraints by higher collateral requirements on capital, in order to limit default risk and improve social welfare. The results show that belief heterogeneity determines the effectiveness of macro-prudential policies. When belief heterogeneity is large, increasing collateral requirements on capital increases social welfare, while when belief heterogeneity is small, higher collateral requirements reduce social welfare. This calls for financial innovation as an additional macro-prudential policy tool. It takes the form of collateral hedging, which enables collateral protection insurance contracts along with capital to serve as collateral. The results also rationalize the observations of the effectiveness of macro-prudential policies towards stabilizing asset prices and stimulating the real economy in the US. In the third paper, I develop a general framework to characterize optimal macro-prudential policies, in the form of taxes or subsidies on asset trading. I also conduct a comparison between economies with endogenous and exogenous collateral constraints. The endogeneity of margins, on borrowing in the former economy, which plays no role in the latter economy, generates pecuniary externalities that determine the tax schedules. The results show that the level and sign of tax schedules may differ between two economies as I perturb income to loose collateral constraints; while the response of tax schedules to higher uncertainty of collateral dividends is smooth in the economy with endogenous margins, in contrast to a non-linear response to higher uncertainty in the economy with endogenous margins.