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Housing and Banking in a Small Open Economy DSGE Model

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  • Viktors Ajevskis
  • Kristine Vitola

Abstract

The severe repercussions of the latest financial crisis highlighted the crucial role of the financial sector in the propagation of economic and financial shocks. In this paper we analyse the role of financial market frictions in business cycle fluctuations and in the transmission of monetary policy in a small open economy pursuing fixed exchange rate strategy. To this end, we develop and estimate a DSGE model for Latvia with financially constrained households and firms, embedding monopolistically competitive banking sector facing capital constraints. This general equilibrium framework is useful to study the potential of macro-prudential tools and their interaction with other macroeconomic and monetary policy instruments. Our findings suggest that the banking sector mutes the response of bank retail rates to an increase in the foreign policy rate and thus attenuates the drop in real aggregates. A permanent bank capital contraction subdues output, consumption, investment, domestic lending and foreign borrowing in the long run. Under a temporary shock to bank capital, asset prices and housing investment are first to recover, for loans it takes several years, while output, consumption and capital investment rebound at a slower pace. In the long run, a tighter capital requirement leads to higher output, capital investment and domestic lending while reducing household deposits and foreign liabilities of banks.

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Bibliographic Info

Paper provided by Latvijas Banka in its series Working Papers with number 2011/03.

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Date of creation: 03 Nov 2011
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Handle: RePEc:ltv:wpaper:201103

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Related research

Keywords: DSGE; DSGE models; Bayesian estimation; banks; financial frictions; macro-financial linkages; small open economy;

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References

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  1. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
  2. Matteo Iacoviello & Stefano Neri, 2007. "Housing Market Spillovers: Evidence from an Estimated DSGE Model," Boston College Working Papers in Economics 659, Boston College Department of Economics, revised 23 Oct 2009.
  3. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June.
  4. Kolasa, Marcin & Lombardo, Giovanni, 2011. "Financial frictions and optimal monetary policy in an open economy," Working Paper Series 1338, European Central Bank.
  5. Malin Adolfson & Stefan Laseen & Jesper Lindé & Mattias Villani, 2005. "An estimated New Keynesian small open economy model," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  6. Andrea Gerali & Stefano Neri & Luca Sessa & Federico M. Signoretti, 2010. "Credit and Banking in a DSGE Model of the Euro Area," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 107-141, 09.
  7. Darracq Pariès, Matthieu & Kok, Christoffer & Rodriguez-Palenzuela, Diego, 2010. "Macroeconomic propagation under different regulatory regimes: Evidence from an estimated DSGE model for the euro area," Working Paper Series 1251, European Central Bank.
  8. Viktors Ajevskis & Kristine Vitola, 2009. "Advantages of Fixed Exchange Rate Regime from a General Equilibrium Perspective," Working Papers 2009/04, Latvijas Banka.
  9. Scott Roger & Jan Vlcek, 2011. "Macroeconomic Costs of Higher Bank Capital and Liquidity Requirements," IMF Working Papers 11/103, International Monetary Fund.
  10. Ian Christensen & Paul Corrigan & Caterina Mendicino & Shin-Ichi Nishiyama, 2009. "Consumption, Housing Collateral, and the Canadian Business Cycle," Working Papers 09-26, Bank of Canada.
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Cited by:
  1. PIROVANO, Mara, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Papers 2013014, University of Antwerp, Faculty of Applied Economics.
  2. Краснопёров, Олег, 2012. "Оценка Производственной Функции В Условиях Неопределённости Динамики Физического Капитала
    [Assessing the production
    ," MPRA Paper 47555, University Library of Munich, Germany.

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