The subject of this dissertation is financial stability and its role in macroeconomic policy. In the first chapter I study whether it is central bank should take into account household indebtedness when deciding about the level of nominal interest rate. High level of household debt has been associated with many financial crises and as therefore it is important to control the level of indebtedness in normal times. I answer this question using a standard macroeconomic model extended for the presence of so-called hand-to-mouth borrowers – households who consume all their disposable income net of debt payments. Using that model I show what is the optimal simple policy rule – depending on the variable that enters the rule and depending on the mortgage type available in the model economy. I then compare the policy prescriptions based on my model, that I argue accounts for a realistic behavior of households, to the conclusions based on the standard macroeconomic model that is frequently used to analyze the merits of different policy rules. In the second chapter I answer the question whether it is possible to early detect financial distress. I define financial distress as situation in which financial intermediation is either costly or impossible (or both) as proxied by tight financial conditions – high spreads, decline in equity value and high volatility. Tight financial conditions have been identified as risk factor to the medium-run GDP growth. I therefore use different statistical methods aiming at extracting early warning signals from the cross-country data related to financial health and soundness of countries' financial systems. The novelty of my approach is that I account for class imbalance – that is I adjust my results for the fact that financial distress period are rare event. I contrast that to the previous literature. I find that it is possible to generate accurate warning signals about future distress well in advance. I show that this finding is robust to the definition of the financial distress. In the third chapter I analyze the differences between how agents perceive the net benefits of macroprudential regulation. To this end, I modify a simple model in which agents have heterogeneous beliefs about future price of risky asset. In my model this risky asset is housing that can be used to fulfill shelter needs or it can be rented. I show that unrestricted borrowing leads to excessive price increase and lower social welfare, while loan to value regulation corrects this excessive borrowing by optimists. The novel insight I provide is related to the discrepancy in perception of net benefits of regulation. Agents have distorted beliefs and therefore optimists perceive that they lose because they can borrow less when loan to value limit is active. However, it turns out that their incorrect beliefs severely underestimate the gain from loan to value limit.
