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The adverse feedback loop and the effects of risk in both the real and financial sectors

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  • Scott Davis

Abstract

Recessions that are accompanied by financial crises tend to be more severe and are followed by slower recoveries than ordinary recessions. This paper introduces a new Keynesian model with financial frictions on both the demand and supply side of the credit markets that can explain this empirical finding. Following a shock that leads to a decline in economic activity, an adverse feedback loop arises where falling profits and asset values lead to increased defaults in the real sector, and these increased defaults lead to increased loan losses in the banking sector. Following this increase in loan losses, financial frictions in the banking sector imply that the banking sector itself may face difficulty obtaining funds. This disruption in the intermediation process leads to a further decline in output and asset prices in the real sector. In simulations of the model it is found that this feedback loop operating through the balance sheets of financial intermediaries can lead to as much as a 20 percent increase in business cycle volatility, and impulse response analysis shows that in the presence of financial frictions the path back to the steady state after a shock is much slower.

Suggested Citation

  • Scott Davis, 2010. "The adverse feedback loop and the effects of risk in both the real and financial sectors," Globalization and Monetary Policy Institute Working Paper 66, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddgw:66
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    Citations

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    Cited by:

    1. Sami Alpanda & Gino Cateau & Cesaire Meh, 2014. "A policy model to analyze macroprudential regulations and monetary policy," BIS Working Papers 461, Bank for International Settlements.
    2. Uluc Aysun & Ralf Hepp, 2014. "A comparison of the internal and external determinants of global bank loans: Evidence from bilateral cross-country data," Working Papers 2014-01, University of Central Florida, Department of Economics.
    3. Alpanda, Sami & Aysun, Uluc, 2014. "International transmission of financial shocks in an estimated DSGE model," Journal of International Money and Finance, Elsevier, vol. 47(C), pages 21-55.
    4. Enders, Zeno & Peter, Alexandra, 2015. "Global Banking, Trade, and the International Transmission of the Great Recession," Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 113022, Verein für Socialpolitik / German Economic Association.
    5. Scott Davis & Kevin X. D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization and Monetary Policy Institute Working Paper 85, Federal Reserve Bank of Dallas.
    6. Uluc Aysun, 2013. "Bank size and macroeconomic shock transmission: Are there economic volatility gains from shrinking large, too big to fail banks?," Working Papers 2013-02, University of Central Florida, Department of Economics.
    7. repec:fip:feddgm:00014 is not listed on IDEAS
    8. repec:eee:jmacro:v:54:y:2017:i:pb:p:161-186 is not listed on IDEAS
    9. Hristov, Nikolay & Hülsewig, Oliver, 2017. "Unexpected loan losses and bank capital in an estimated DSGE model of the euro area," Journal of Macroeconomics, Elsevier, vol. 54(PB), pages 161-186.
    10. Kuang-Liang Chang & Nan-Kuang Chen & Charles Ka Yui Leung, 2016. "Losing Track of the Asset Markets: the Case of Housing and Stock," International Real Estate Review, Asian Real Estate Society, vol. 19(4), pages 435-492.
    11. Aysun, Uluc, 2015. "Duration of bankruptcy proceedings and monetary policy effectiveness," Journal of Macroeconomics, Elsevier, vol. 44(C), pages 295-302.
    12. Davis, Scott, 2011. "Financial integration and international business cycle co-movement: the role of balance sheets," Globalization and Monetary Policy Institute Working Paper 89, Federal Reserve Bank of Dallas.

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    Keywords

    Business cycles - Econometric models ; Financial markets ; International finance ; Financial crises ; Recessions;

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