DP15133 Financial Frictions: Macro vs Micro Volatility

Author(s): Seungcheol Lee, Ralph Luetticke, Morten O Ravn
Publication Date: August 2020
Date Revised: September 2020
Keyword(s): business cycles, Financial Frictions, incomplete markets, macroprudential policy, monetary policy
JEL(s): C11, D31, E32, E63
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15133

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.