Discussion Paper Details

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Title: Financial Frictions: Macro vs Micro Volatility

Author(s): Seungcheol Lee, Ralph Luetticke and Morten O Ravn

Publication Date: August 2020

Keyword(s): business cycles, Financial Frictions, incomplete markets, macroprudential policy and monetary policy

Programme Area(s): Monetary Economics and Fluctuations

Abstract: We examine the impact of frictional financial intermediation in a HANK model. An incentive problem restricts banking sector leverage and gives rise to an equilibrium spread between the returns on savings and debt. The size of this spread impacts on the wealth distribution and movements in it subject borrowers and savers to different intertemporal prices. The model generates a financial accelerator that is larger than in a representative agent setting, derives mainly from consumption rather than investment, and works through a countercyclical interest rate spread. Credit policy can mute this mechanism while stricter regulation of banking sector leverage inhibits households' ability to smooth consumption in response to idiosyncratic risk. Thus, although leverage restrictions stabilize at the aggregate level, we find substantial welfare costs.

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Bibliographic Reference

Lee, S, Luetticke, R and Ravn, M. 2020. 'Financial Frictions: Macro vs Micro Volatility'. London, Centre for Economic Policy Research.