The essence of central banking lies in the pursuit of macroeconomic and financial stability. There are complete models of macroeconomic stability, and a reasonably broad consensus on how to achieve it. Not so for financial stability. There is no consensus how to achieve it, nor a widely accepted model.
This paper studies the relation between asset prices and the banking system. This relation is a suitable reduction, having been a central element, and a major policy concern, in many episodes of financial instability. To do so requires going beyond existing macroeconomic models in three ways. First, the model incorporates a banking system that intermediates the payments supporting the asset market. Second, we allow default and loan losses to affect the banking system. Finally, we avoid log-linearization to incorporate financial extremes far from the steady state.
More precisely, we propose an overlapping-generations model designed for assets to play a central role, as in Kiyotaki and Moore (1997), and for banks to intermediate payments, as in Black (1970) or McAndrews and Roberds (1999). The model works as follows. Firms purchase productive assets on bank credit. Next period, they resell them to the new generation of firms, and sell their output at the new price level. While undisturbed, the economy remains in steady state.
1 The Basic Model
- 1.1 Firms
1.3 The Banking System
1.4 Perfect Foresight Equilibrium
2 Effect on the Banking System
- 2.1 Reactions to a Shock
2.2 Fundamental Equilibrium
3 Feedback from the Banking System
- 3.1 Capital-Constrained Equilibrium
3.2 Financial Extremes
4 Policy Implications
- 4.1 Macroeconomic versus Financial Stability
4.2 Monetary Policy and Asset Prices
4.3 Regulatory Implications
5 Case Studies
- 5.1 Japan’s Lost Decade
5.2 The Nordic Banking Crises
5.3 The US Great Depression