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Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions

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  • Luk, Sheung Kan
  • Vines, David

Abstract

This paper adds a highly-leveraged financial sector to the Ramsey model of economic growth and shows that this causes the economy to behave in a highly volatile manner: doing this strongly augments the macroeconomic effects of aggregate productivity shocks. Our model is built on the financial accelerator approach of Bernanke, Gertler and Gilchrist (BGG), in which leveraged goods-producers, subject to idiosyncratic productivity shocks, borrow from a competitive financial sector. In the present paper, by contrast, it is the financial institutions which are leveraged and subject to idiosyncratic productivity shocks. Financial institutions can only obtain their funds by paying an interest rate above the risk-free rate, and this risk premium is anti-cyclical, and so augments the effects of shocks. Our parameterisation, based on US data, is one in which the leverage of the financial sector is two and a half times that of the goods-producers in the BGG model. This causes a much more significant augmentation of aggregate productivity shocks than that which is found in the BGG model.

Suggested Citation

  • Luk, Sheung Kan & Vines, David, 2011. "Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions," CEPR Discussion Papers 8576, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:8576
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    References listed on IDEAS

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    1. repec:bla:ecinqu:v:55:y:2017:i:1:p:565-579 is not listed on IDEAS
    2. 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, September.
    3. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
    4. Naohisa Hirakata & Nao Sudo & Kozo Ueda, 2017. "Chained Credit Contracts And Financial Accelerators," Economic Inquiry, Western Economic Association International, vol. 55(1), pages 565-579, January.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    financial accelerator; highly leveraged financial institutions; leverage; volatility;

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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