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Financial capital and the macroeconomy: a quantitative framework

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Author Info

  • Michael T. Kiley
  • Jae W. Sim

Abstract

Financial intermediation transforms short-term liquid assets into long-term capital assets. As a result, risk taking, in the form of long-term commitments despite unresolved short-term funding risk, is an essential element of intermediation. If such funding risk must be addressed by costly recapitalization and/or distressed asset sales due to capital market frictions, an increase in uncertainty can cause a disruption in the intermediation process by forcing risk-neutral intermediaries to behave in a risk-averse manner. Our analysis examines this behavior theoretically and empirically. We first develop a dynamic macroeconomic model in which the balance sheet/liquidity condition of financial intermediaries plays an important role in the determination of asset prices and economic activity under time-varying uncertainty. Second, we present new evidence on the importance of uncertainty facing financial intermediaries for credit terms and volume and for aggregate economic activity, thereby partially quantifying the significance of capital market frictions. We adopt a structural identification strategy in which the predictions of our theory, in the form of sign restrictions, play an important role.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2011-27.

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Date of creation: 2011
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Handle: RePEc:fip:fedgfe:2011-27

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Related research

Keywords: Capital market ; Intermediation (Finance) ; Financial institutions;

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References

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  1. Juan F. Rubio-Ramírez & Daniel F.Waggoner & Tao Zha, 2008. "Structural vector autoregressions: theory of identification and algorithms for inference," Working Paper 2008-18, Federal Reserve Bank of Atlanta.
  2. Van den Heuvel, Skander J., 2008. "The welfare cost of bank capital requirements," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 298-320, March.
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Cited by:
  1. Tobias Adrian, 2012. "Discussion of “An Integrated Framework for Multiple Financial Regulations”," Staff Reports 583, Federal Reserve Bank of New York.
  2. Bank for International Settlements, 2012. "Operationalising the selection and application of macroprudential instruments," CGFS Papers, Bank for International Settlements, number 48, January.
  3. Seung Jung Lee & Viktors Stebunovs, 2012. "Bank capital ratios and the structure of nonfinancial industries," Finance and Economics Discussion Series 2012-53, Board of Governors of the Federal Reserve System (U.S.).

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