Economic recessions, i.e. GDP contraction, have been studied thoroughly within the Real Business Cycle paradigm. The underlying intuition is that they are caused by adverse productivity shocks. The role of monetary policy is to stabilize prices and the function of the financial sector to facilitate the transfer of funds from depositors to entrepreneurs and the production sector. This literature has traditionally assumed that explicit modeling of banking activity was unnecessary, since it is commonly concluded that monetary policy and its effect on credit extension are neutral in the long-run.
The purpose of this paper is to examine the effects of monetary policy on total output within a framework of fully flexible prices. The underlying friction is that we allow agents to (endogenously) default on their long-term loan obligations. Thus, the need for collateral to back these loans arises. In all other respects, we maintain all the structural characteristics of General Equilibrium analysis, i.e. optimizing behavior, perfectly competitive markets and rational expectations. An advantage of our model is that it yields closed-from results.
Hence, we are able to identify clearly the propagation mechanism and present the unfolding of events, through which monetary policy affects the decision to default and subsequently the allocation of capital and total output. To that extent we do not engage in a detailed discussion of optimal monetary policy, but rather propose default as an additional channel for affecting aggregate output.
The financial crisis of 2007 and its subsequent adverse effect on GDP has been a vivid example that requires a new methodological approach. The RBC literature cannot adequately address the issues arising from this crisis, since it is challenging if not impossible to justify that a recession preceded the large number of mortgage defaults and the subsequent pessimism in the banking sector that resulted in credit contraction. It would require a nontrivial degree of irrationality, since expectations had been very optimistic. Canonical DSGE models face the same inadequacy, since they have not paid much attention on credit frictions, heterogeneity and most importantly the possibility of endogenous default.
