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Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence

Listed author(s):
  • G. Kemal Ozhan

    ()

    (University of St Andrews)

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.

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File URL: http://www.st-andrews.ac.uk/~wwwecon/repecfiles/4/1704.pdf
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Paper provided by Department of Economics, University of St. Andrews in its series Discussion Paper Series, Department of Economics with number 201704.

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Date of creation: 17 Feb 2017
Handle: RePEc:san:wpecon:1704
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