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Can Financial Intermediation Induce Economic Fluctuations?

Listed author(s):
  • Sanjay Banerji
  • Ngo Van Long

We construct a model to show that active financial intermediation can induce economic fluctuations. We embed a financial sector in a simple overlapping generation model with a single stock of capital. Individuals are risk averse agents that face idiosyncratic risks in their business activities: Due to limited liability, agents have incentives to invest in a technology that produces high output with a smaller probability. Financial intermediaries (FIs) are risk neutral. We distinguish two scenarios. The first scenario is one with active financial intermediation: the FIs lends only on the conditions that borrowers accept restrictions on their investments. In the second scenario, financial intermediation is passive, in that the FIs lend without monitoring the activities of the borrowers. For a given loan size, the investment level under active financial intermediation is shown to be smaller than under passive financial intermediation. This fact alone creates, in the first scenario, an income effect that may generate fluctuations in investment. (This effect is absent under passive financial intermediation, and, as a result, in our model there are no fluctuations under passive financial intermediation.) Thus business cycles and possibly chaotic dynamics can be, under certain conditions, generated by active intermediation. On étudie un modèle qui montre que l'intermédiation active des institutions financières peut générer les fluctuations. Il s'agit d'un modèle aux générations imbriquées avec un stock de capital. Les individus sont riscophobes, tandis que les institutions financières (I.F.) ne le sont pas. On considère deux cas. Dans le premier cas, les I.F. sont actives: elles prêtent de l'argent sous la condition que les emprunteurs acceptent des restrictions sur leurs choix de projets d'investissement. Dans le deuxième cas, les I.F. sont passives. Nous démontrons que si les I.F. sont actives, les conditions de prêts peuvent créer un effet de richesse qui peut générer les fluctuations du taux d'investissement, et du P.I.B.

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Paper provided by CIRANO in its series CIRANO Working Papers with number 2000s-51.

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Length: 26 pages
Date of creation: 01 Nov 2000
Handle: RePEc:cir:cirwor:2000s-51
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  1. Boldrin, Michele & Woodford, Michael, 1990. "Equilibrium models displaying endogenous fluctuations and chaos : A survey," Journal of Monetary Economics, Elsevier, vol. 25(2), pages 189-222, March.
  2. de Meza, David & Webb, David, 1999. "Wealth, Enterprise and Credit Policy," Economic Journal, Royal Economic Society, vol. 109(455), pages 153-163, April.
  3. Allen, Franklin & Gale, Douglas, 1997. "Financial Markets, Intermediaries, and Intertemporal Smoothing," Journal of Political Economy, University of Chicago Press, vol. 105(3), pages 523-546, June.
  4. Bruce D. Smith, 1991. "Interest on Reserves and Sunspot Equilibria: Friedman's Proposal Reconsidered," Review of Economic Studies, Oxford University Press, vol. 58(1), pages 93-105.
  5. Schreft, Stacey L. & Smith, Bruce D., 1997. "Money, Banking, and Capital Formation," Journal of Economic Theory, Elsevier, vol. 73(1), pages 157-182, March.
  6. Grandmont, Jean-Michel, 1985. "On Endogenous Competitive Business Cycles," Econometrica, Econometric Society, vol. 53(5), pages 995-1045, September.
  7. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  8. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  9. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, July.
  10. Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
  11. Rajan, Raghuram G, 1992. " Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt," Journal of Finance, American Finance Association, vol. 47(4), pages 1367-1400, September.
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