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Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence

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  • G. Kemal Ozhan

    (University of St Andrews)

Abstract

This paper studies the role of the financial sector in affecting domestic resource allocation and cross-border capital flows. I develop a quantitative, two-country, macroeconomic model in which banks face endogenous and occasionally binding leverage constraints. Banks lend funds to be invested in tradable or non-tradable sector capital and there is international financial integration in the market for bank liabilities. I focus on news about economic fundamentals as the key source of fluctuations. Specifically, in the case of positive news on the valuation of non-traded sector capital that turn out to be incorrect at a later date, the model generates an asymmetric, belief-driven boom-bust cycle that reproduces key features of the recent Eurozone crisis. Bank balance sheets amplify and propagate fluctuations through three channels when leverage constraints bind: First, amplified wealth effects induce jumps in import-demand (demand channel). Second, changes in the value of non-tradable sector assets alter bank lending to tradable sector firms (intra-national spillover channel). Third, domestic and foreign households re-adjust their savings in domestic banks, and capital flows further amplify fluctuations (international spillover channel). A common central bank’s unconventional policies of private asset purchases and liquidity facilities in response to unfulfilled expectations are successful at ameliorating the economic downturn.

Suggested Citation

  • G. Kemal Ozhan, 2017. "Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence," CDMA Working Paper Series 201701, Centre for Dynamic Macroeconomic Analysis.
  • Handle: RePEc:san:cdmawp:1701
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    More about this item

    Keywords

    Bank Lending; Belief-Driven Dynamics; Current Account; Macroeconomic Interdependence;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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