The growth effects of financial volatility, and ways to mitigate them, have been largely absent from recent discussions about the implications of the global financial crisis for financial reform. However, understanding the longer run effects of financial regulation is essential because of the potential trade-off associated with the fact that regulatory policies, designed to reduce procyclicality and the risk of financial crises, could well be detrimental to long-run economic growth, due to their effect on risk taking and incentives to borrow and lend—despite contributing to a more stable environment in which agents can assess risks and returns associated with their investment decisions. Dwelling on a recent analytical contribution, this policy brief argues that macroprudential policy, especially in low-income countries, should internalize this trade-off. The case of reserve requirements is discussed, given the importance of this instrument in these countries.
