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  3. American Economic Journal: Macroeconomics
  4. October 2016
  5. Financial Intermediation, Leverage, and Macroeconomic Instability

Financial Intermediation, Leverage, and Macroeconomic Instability

  • Gregory Phelan
American Economic Journal: Macroeconomics
vol. 8, no. 4, October 2016
(pp. 199-224)
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Abstract

This paper investigates how financial sector leverage affects macroeconomic instability and welfare. In the model, banks borrow (use leverage) to allocate resources to productive projects and provide liquidity. When banks do not actively issue new equity, aggregate outcomes depend on the level of equity in the financial sector. Equilibrium is inefficient because agents do not internalize how their decisions affect volatility, aggregate leverage, and the returns on assets. Leverage creates systemic risk, which increases the frequency and duration of crises. Limiting leverage decreases asset price volatility and increases expected returns, which decrease the likelihood that the financial sector is undercapitalized.

Citation

Phelan, Gregory. 2016. "Financial Intermediation, Leverage, and Macroeconomic Instability." American Economic Journal: Macroeconomics, 8 (4): 199-224. DOI: 10.1257/mac.20140233

Additional Materials

JEL Classification

  • E32 Business Fluctuations; Cycles
  • E44 Financial Markets and the Macroeconomy
  • G01 Financial Crises
  • G21 Banks; Depository Institutions; Micro Finance Institutions; Mortgages
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