Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions

50 Pages Posted: 21 Sep 2011

See all articles by Sheung Kan Luk

Sheung Kan Luk

affiliation not provided to SSRN

David Vines

University of Oxford - Balliol College - Department of Economics; Australian National University (ANU); Centre for Economic Policy Research (CEPR)

Date Written: September 2011

Abstract

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.

Keywords: financial accelerator, highly leveraged financial institutions, leverage, volatility

JEL Classification: E22, E32, E44

Suggested Citation

Luk, Sheung Kan and Vines, David, Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions (September 2011). CEPR Discussion Paper No. DP8576, Available at SSRN: https://ssrn.com/abstract=1931085

Sheung Kan Luk (Contact Author)

affiliation not provided to SSRN ( email )

No Address Available

David Vines

University of Oxford - Balliol College - Department of Economics ( email )

Manor Road
Oxford, OX1 3BJ, Oxfordshire OX13UQ
United Kingdom
+44 1865 271 067 (Phone)
+44 1865 271 094 (Fax)

Australian National University (ANU)

Canberra, Australian Capital Territory
Australia

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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