Financial Instability and the Macroeconomy
Saturday, Jan. 5, 2019 2:30 PM - 4:30 PM
- Chair: Luc Laeven, European Central Bank
Money Markets, Collateral and Monetary Policy
AbstractWe analyze the impact of money market frictions on the macroeconomy and on the conduct of monetary policy. We focus on two key developments in European money markets: i) declining activity in the unsecured market segment, and ii) increased exposure to secured funding and to fluctuations in collateral value. We build a general equilibrium model with secured and unsecured money markets, and a central bank that can conduct open market operations as well as lend to banks against collateral. We find that reduced access to the unsecured market leads to moderate output contractions as long as banks can substitute into secured funding. If secured money market funding is limited, due to high haircuts or scarcity of collateral assets, output contractions can be substantial. A central bank that expands the size of its balance sheet is able to mitigate such adverse impact. A policy of quantitative easying that aims at stabilizing inflation is more effective than a policy of unlimited liquidity provision against collateral.
Extreme Financial Distress and the Macroeconomy: A New Framework
AbstractThis paper studies the interaction between banks' and firms' defaults and the transmission of financial distress to the macroeconomy. We develop a tractable framework which allows us to match the relative default frequencies of corporate and bank defaults as well as their correlation. The model also reproduces the fact that macro-economic outcomes are significantly worse when both firms and banks default rates are high. We argue that endogenous risk-taking by banks increases in response to shocks that elevate the riskiness of bank portfolio and drives much of the crisis dynamics in the model. When banks under-price risk, both firm and bank default rates are high and sequences of otherwise small shocks can push the economy into a financial crisis and a deep recession. In contrast, when banks take less risk, they remain resilient despite high corporate defaults and there is no strong amplification of aggregate shocks.
Risk Sharing and Amplification
AbstractMacroeconomic models with a financial accelerator mechanism are built around two main ingredients: a collateral constraint and incomplete financial markets. The first ingredient implies that shocks affecting the balance sheet of some agents affect their investment decisions, while the second ingredient guarantees that the same agents cannot hedge these shocks. A commonly held view in the literature is that both ingredients are necessary for the model to produce amplified responses to aggregate shocks. In this paper we revisit this view. In particular, we focus on a general equilibrium spillover, by which a reduction of the net worth of financially constrained agents lowers incomes and consumption levels in the rest of economy. The presence of the spillover makes hedging costly for the financially constrained agents and leads to amplification even in presence of complete financial markets. Numerical simulations show that this force is quantitatively relevant, as under plausible calibrations the competitive equilibrium with complete markets features a similar degree of amplification as the one with incomplete markets. The same spillover also implies that the competitive equilibrium is constrained inefficient and provides a rationale for financial regulations that reduce the exposure of financial institutions to aggregate risk.
- E3 - Prices, Business Fluctuations, and Cycles
- G1 - General Financial Markets