DP8576 Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions

Author(s): Sheung Kan Luk, David Vines
Publication Date: September 2011
Keyword(s): financial accelerator, highly leveraged financial institutions, leverage, volatility
JEL(s): E22, E32, E44
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8576

This paper adds a highly-leveraged financial sector to the Ramsey model of economic growth and shows that this causes the economy to behave in a highly volatile manner: doing this strongly augments the macroeconomic effects of aggregate productivity shocks. Our model is built on the financial accelerator approach of Bernanke, Gertler and Gilchrist (BGG), in which leveraged goods-producers, subject to idiosyncratic productivity shocks, borrow from a competitive financial sector. In the present paper, by contrast, it is the financial institutions which are leveraged and subject to idiosyncratic productivity shocks. Financial institutions can only obtain their funds by paying an interest rate above the risk-free rate, and this risk premium is anti-cyclical, and so augments the effects of shocks. Our parameterisation, based on US data, is one in which the leverage of the financial sector is two and a half times that of the goods-producers in the BGG model. This causes a much more significant augmentation of aggregate productivity shocks than that which is found in the BGG model.