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Financial capital and the macroeconomy: policy considerations

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  • Michael T. Kiley
  • Jae W. Sim

Abstract

We 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 Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2011-28.

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Date of creation: 2011
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Handle: RePEc:fip:fedgfe:2011-28

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Related research

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

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  1. Skander Van den Heuvel, 2005. "The Welfare Cost of Bank Capital Requirements," 2005 Meeting Papers 880, Society for Economic Dynamics.
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