Countercyclical capital regulation in a small open economy DSGE model

We assess the macroeconomic performance of different countercyclical capital buffer rules, where regulatory capital responds to deviation from a long-run trend in the credit-to-GDP ratio (the credit gap), in a medium scale DSGE model of the Irish economy. We find that rules based on the credit gap create a trade-off between the stabilisation of fluctuations originating in the housing market (which are attenuated) and stabilisation of fluctuations caused by foreign demand shocks (which are amplified) because the credit gap is not always procyclical. The trade-off disappears if the regulator follows a rule based on house prices instead of the credit gap.