Discussion Paper Details

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Title: The Macroeconomics of Modigliani-Miller

Author(s): Hans Gersbach, Hans Haller and Jürg Müller

Publication Date: March 2013

Keyword(s): Banking, Capital Requirements, Capital Structure, Financial intermediation, General Equilibrium and Modigliani-Miller

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: We examine the validity of a macroeconomic version of the Modigliani-Miller theorem. For this purpose, we develop a general equilibrium model with two production sectors, risk-averse households and financial intermediation by banks. Banks are funded by deposits and (outside) equity and monitor borrowers in lending. We impose favorable manifestations of the underlying frictions and distortions. We obtain two classes of equilibria. In the first class, the debt-equity ratio of banks is low. The first-best allocation obtains and banks' capital structure is irrelevant for welfare: a macroeconomic version of the Modigliani-Miller theorem. However, there exists a second class of equilibria with high debt-equity ratios. Banks are larger and invest more in risky technologies. Default and bailouts financed by lump sum taxation occur with positive probability and welfare is lower. Imposing minimum equity capital requirements eliminates all inefficient equilibria and guarantees the global validity of the macroeconomic version of the Modigliani-Miller theorem.

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Bibliographic Reference

Gersbach, H, Haller, H and Müller, J. 2013. 'The Macroeconomics of Modigliani-Miller'. London, Centre for Economic Policy Research.