Lien Laureys, Mr. Roland Meeks, and Boromeus Wanengkirtyo
We reconsider the design of welfare-optimal monetary policy when financing frictions impair the supply of bank credit, and when the objectives set for monetary policy must be simple enough to be implementable and allow for effective accountability. We show that a flexible inflation targeting approach that places weight on stabilizing inflation, a measure of resource utilization, and a financial variable produces welfare benefits that are almost indistinguishable from fully-optimal Ramsey policy. The macro-financial trade-off in our estimated model of the euro area turns out to be modest, implying that the effects of financial frictions can be ameliorated at little cost in terms of inflation. A range of different financial objectives and policy preferences lead to similar conclusions.
We study how financial frictions amplify labor supply shocks in a macroeconomic model with occasionally binding financing constraints. Workers supply labor to entrepreneurs who borrow to purchase factors of production. Borrowing capacity is restricted by the value of capital, generating a pecuniary externality when financing constraints bind. Additionally, there is a distributive externality operating through wages. The planner’s allocation can be decentralized with two instruments: a credit tax/subsidy and a labor tax/subsidy. Labor shocks, such as the COVID-19 shock, amplify the policy responses, which critically depend on whether financing constraints bind or not.
We study the impact of bank credit on firm productivity. We exploit a matched firm-bank
database covering all the credit relationships of Italian corporations, together with a natural
experiment, to measure idiosyncratic supply-side shocks to credit availability and to estimate
a production model augmented with financial frictions. We find that a contraction in credit
supply causes a reduction of firm TFP growth and also harms IT-adoption, innovation,
exporting, and adoption of superior management practices, while a credit expansion has
limited impact. Quantitatively, the credit contraction between 2007 and 2009 accounts for
about a quarter of observed the decline in TFP.
This paper studies private investment in India against the backdrop of a significant investment
decline over the past decade. We analyze the potential causes of weaker investment at the firm
level, using both firm-level financial statements and a novel dataset on firms’ investment project
decisions, and find that financial frictions have played a role in the slowdown. Firms with higher
financial leverage invest less, as do firms with lower earnings relative to their interest expenses.
Consistent with the notion of credit constraints leading to pro-cyclical investment, we also find
that firms with higher leverage are (i) less likely to undertake new investment projects, (ii) less
likely to complete investment projects once begun, and (iii) undertake shorter-term investment
Once upon a time, in the 1990s, it was widely agreed that neither Europe nor the United
States was an optimum currency area, although moderating this concern was the finding that
it was possible to distinguish a regional core and periphery (Bayoumi and Eichengreen,
1993). Revisiting these issues, we find that the United States is remains closer to an optimum
currency area than the Euro Area. More intriguingly, the Euro Area shows striking changes
in correlations and responses which we interpret as reflecting hysteresis with a financial
twist, in which the financial system causes aggregate supply and demand shocks to reinforce
each other. An implication is that the Euro Area needs vigorous, coordinated regulation of its
banking and financial systems by a single supervisor—that monetary union without banking
union will not work.
This paper develops a model featuring both a macroeconomic and a financial friction that
speaks to the interaction between monetary and macro-prudential policies. There are two main
results. First, real interest rate rigidities in a monopolistic banking system have an asymmetric
impact on financial stability: they increase the probability of a financial crisis (relative to the
case of flexible interest rate) in response to contractionary shocks to the economy, while they
act as automatic macro-prudential stabilizers in response to expansionary shocks. Second, when
the interest rate is the only available policy instrument, a monetary authority subject to the same
constraints as private agents cannot always achieve a (constrained) efficient allocation and faces
a trade-off between macroeconomic and financial stability in response to contractionary shocks.
An implication of our analysis is that the weak link in the U.S. policy framework in the run up
to the Global Recession was not excessively lax monetary policy after 2002, but rather the
absence of an effective regulatory framework aimed at preserving financial stability.
The limited access to bank credit in recent years has increased the pressure on small and medium size enterprises (SMEs), forcing them to scale down investment plans and production. This paper, which explores the macroeconomic implications of this channel, finds evidence that countries with high prevalence of SMEs tended to recover more slowly from the global financial crisis than their peers, implying that the interaction of the economic structure and access to bank financing plays a critical role in episodes of economic recovery. This conclusion is reinforced by a VAR estimation, which demonstrates that a negative credit supply shock applied to SMEs has an adverse effect on economic activity, and this impact is amplified in countries that have a high share of SMEs.
Recent studies show that uncertainty shocks have quantitatively important effects on the real economy. This paper examines one particular channel at work: the supply of credit. It presents a model in which a bank, even if managed by risk-neutral shareholders and subject to limited liability, can exhibit self-insurance, and thus loan supply contracts when uncertainty increases. This prediction is tested with the universe of U.S. commercial banks over the period 1984-2010. Identification of credit supply is achieved by looking at the differential response of banks according to their level of capitalization. Consistent with the theoretical predictions, increases in uncertainty reduce the supply of credit, more so for banks with lower levels of capitalization. These results are weaker for large banks, and are robust to controlling for the lending and capital channels of monetary policy, to different measures of uncertainty, and to breaking the dataset in subsamples. Quantitatively, uncertainty shocks are almost as important as monetary policy ones with regards to the effects on the supply of credit.
This paper surveys dynamic stochastic general equilibrium models with financial frictions in use by central banks and discusses priorities for future development of such models for the purpose of monetary and financial stability analysis. It highlights the need to develop macrofinancial models which allow analysis of the macroeconomic effects of macroprudential policy tools and to evaluate elements of the Basel III reforms as a priority. The paper also reviews the main approaches to introducing financial frictions into general equilibrium models.