Financial Intermediation, Leverage, and Macroeconomic Instability

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 pro vide 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. (JEL E32, E44, G01, G21)

Should Monetary Policy Target Financial Stability?

“…Thus, outcomes will depend on the level of equity in the banking sector. The model combines, with modifications, elements of the models in Phelan (2016) andDrechsler et al (2018).…”

“…We now analyze the global dynamics of equilibrium to consider the positive effects of monetary policy on macroeconomic stability. We solve the model numerically using the parameters from Phelan (2016) and Drechsler et al (2018). The two most important variables are volatility σ and the monetary policy transmission value γ.…”

“…Related Literature Methodologically, our paper follows the stochastic continuous-time macro literature, pioneered by Brunnermeier and Sannikov (2014, 2015, 2016 and He and Krishnamurthy (2012, 2013, 2014, who analyze the nonlinear global dynamics of economies with financial frictions, building on seminal results from Bernanke and Gertler (1989); Kiyotaki and Moore (1997); Bernanke et al (1999). Within this literature, we combine the models of Drechsler et al (2018) and Phelan (2016) to study how monetary policy affects global dynamics. 3 The macroeconomic framework in Phelan (2016) studies how macroprudential policies (i.e., leverage limits) can improve welfare by increasing stability and makes three modifications to the framework in Brunnermeier and Sannikov (2014).…”

“…Within this literature, we combine the models of Drechsler et al (2018) and Phelan (2016) to study how monetary policy affects global dynamics. 3 The macroeconomic framework in Phelan (2016) studies how macroprudential policies (i.e., leverage limits) can improve welfare by increasing stability and makes three modifications to the framework in Brunnermeier and Sannikov (2014). First, the model contains two goods, so that policy may affect the allocation of resources and the returns on different investments.…”

“…Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices and volatility. 4 We embed this model of monetary policy transmission into the Phelan (2016) model to illustrate the state-dependent effects of monetary policies driven by the role of banks in allocating resources to bank-dependent investments. Importantly, monetary policy has different effects on stability depending on the extent to which the returns on different types of investments are affected.…”