Macroprudential Policies in an Open Economy Jorge Pozo * September 2017 Job Market Paper Abstract I build up a two period partially open economy model with domestic and foreign investors and financial intermediaries facing a foreign debt constraint. The key frictions of the model are the limited liability faced by banks and that the individual bank cannot internalize the effect of their decisions on the interest rates. Risky bank loans are funded by domestic and foreign bank debts. Due to these two frictions, banks overestimate the expected present value of future dividends. Thus, capital in equilibrium is inefficiently high and bank risk-taking is excessively high. The novelty and less intuitive result is that under realistic calibration a lower foreign interest rate or a higher access to international credit market decreases the excessive level of capital or the excessive bank risk-taking since the marginal bank debt is domestic and hence the foreign rate affects the marginal cost of credit indirectly through the inefficient additional marginal benefit created by the limited limited. In addition, the limited liability distorts bank liability composition preferences which creates an inefficient low foreign debt share. In this simple model, a macro- prudential policy oriented to reduce the level of risky investment simultaneously restore the credit efficient level and the bank liability composition. Keywords: Limited Liability, Commitment Problem, Bank risk-taking and welfare analysis. JEL Classification: F41, G01, G21, G28. 1 Introduction In the international credit market emerging economies are showing a more active participation and it is expected that the still undeveloped and small banking system in these emerging economies becomes more sophisticated and important. Hence, it is crucial to monitor the impact of higher exposure to the international credit market on * PhD student at Universitat Pompeu Fabra. Email: jorge.pozo@upf.edu 1