Optimal corrective policies under financial frictions

This paper examines credit market policies under pecuniary externalities induced by collateral constraints. Pigouvian taxes/subsidies on debt or savings are derived as Ramsey-optimal policies. Firstly, prudential (ex-ante) debt taxes can restore constrained efficiency. Secondly, when policies are non-state and non-time contingent, debt subsidies can be superior to debt taxes. Thirdly, ex-ante saving subsidies are desirable when distributive effects dominate collateral effects. Fourthly, both effects can simultaneously be addressed by non-contingent saving subsidies. The analysis indicates that optimal policies can improve on constrained efficiency and that inefficiencies due to financial externalities can most effectively be addressed by interest rate reductions.