Overborrowing and Systemic Externalities in the Business Cycle Under Imperfect Information

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 taxing debt procyclically. We show that the combination of imperfect information and borrowing constraints 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