Commodity prices, bank balance sheets and macroprudential policies in small open economies

How important are liability dollarization in the transmission of commodity shocks on business cycles? To address this question, we developed a small open economy DSGE model with a banking sector and financial friction. The banks collect funds in the international capital markets in the form of foreign debt, which is denominated in dollars. Faced with a commodity shock, the results suggest that the presence of liability dollarization generates a greater response output, compared to the model that ignores this financial mechanism. In fact, after simulating a series of shocks in each period, bank balance sheets amplify expansions and deepen economic recessions. Thus, the volatility of business cycles is strongly affected by the presence of liability dollarization. However, the application of countercyclical macroprudential policies, based on Basel III capital requirements, absorbs the impacts of commodity shocks. In addition, this type of policy allows greater gains in social welfare. In summary, it can be pointed out that the bank balance sheets are quantitatively important because they provide information to understand macroeconomic fluctuations.