Financial capital and the macroeconomy: policy considerations
AbstractWe develop a macroeconomic model in which the balance sheet/liquidity condition of financial institutions plays an important role in the determination of asset prices and economic activity. The financial intermediaries in our model are required to make investment commitments before a complete resolution of idiosyncratic funding risk that can be addressed only by costly refinancing, forcing them to behave in a risk-averse manner. The model shows that the balance sheet condition of intermediaries can drive asset values away from their fundamentals, causing aggregate investment and output to respond to shocks to intermediaries. We use this model to evaluate several public policies designed to address balance sheet problems at financial institutions. With regard to short-run policies, we find that capital injections conditioned upon voluntary recapitalization can be a more effective tool than direct lending/asset purchases. With regard to long-run policies, we demonstrate that higher capital requirements can have sizable short-run effects on economic activity if not implemented carefully, and that a long transition period helps avoid such effects.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2011-28.
Date of creation: 2011
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-05-30 (All new papers)
- NEP-CBA-2011-05-30 (Central Banking)
- NEP-DGE-2011-05-30 (Dynamic General Equilibrium)
- NEP-MAC-2011-05-30 (Macroeconomics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Skander Van den Heuvel, 2005.
"The Welfare Cost of Bank Capital Requirements,"
2005 Meeting Papers
880, Society for Economic Dynamics.
- James A. Clouse, 2013. "Monetary policy and financial stability risks: an example," Finance and Economics Discussion Series 2013-41, Board of Governors of the Federal Reserve System (U.S.).
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