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The adverse feedback loop and the effects of risk in both the real and financial sectors

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  • Scott Davis

Abstract

Recessions that are accompanied by financial crises tend to be more severe and are followed by slower recoveries than ordinary recessions. This paper introduces a new Keynesian model with financial frictions on both the demand and supply side of the credit markets that can explain this empirical finding. Following a shock that leads to a decline in economic activity, an adverse feedback loop arises where falling profits and asset values lead to increased defaults in the real sector, and these increased defaults lead to increased loan losses in the banking sector. Following this increase in loan losses, financial frictions in the banking sector imply that the banking sector itself may face difficulty obtaining funds. This disruption in the intermediation process leads to a further decline in output and asset prices in the real sector. In simulations of the model it is found that this feedback loop operating through the balance sheets of financial intermediaries can lead to as much as a 20 percent increase in business cycle volatility, and impulse response analysis shows that in the presence of financial frictions the path back to the steady state after a shock is much slower.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 66.

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Date of creation: 2010
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Handle: RePEc:fip:feddgw:66

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Keywords: Business cycles - Econometric models ; Financial markets ; International finance ; Financial crises ; Recessions;

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Cited by:
  1. Scott Davis, 2011. "Financial integration and international business cycle co-movement: the role of balance sheets," Globalization and Monetary Policy Institute Working Paper 89, Federal Reserve Bank of Dallas.
  2. Uluc Aysun, 2013. "Bank size and macroeconomic shock transmission: Are there economic volatility gains from shrinking large, too big to fail banks?," Working Papers 2013-02, University of Central Florida, Department of Economics.
  3. Scott Davis & Kevin X.D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization and Monetary Policy Institute Working Paper 85, Federal Reserve Bank of Dallas.

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