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Financial Business Cycles

I construct a dynamic stochastic general equilibrium model where leveraged banks amplify the effects on economic activity of given financial shocks. The main questions that I want to address are: (1) To what extent can arbitrary redistributions of wealth disrupt the credit intermediation process that channels funds from savers to borrowers? (2) To what extent can a disruption of the credit intermediation process cause business cycles?

The motivation for these questions comes from the empirical observation that at least two of the last three recessions in the United States (the 1990-91 recession and the 2007-2009 recession) can be ascribed to situations that involved non-repayment on part of some borrowers on the one hand, and loan losses affecting financial institutions on the other. Under this interpretation, it is hard to classify the impulse of these recessions as something that can be easily inserted or found in standard equilibrium macreoconomic models. These models either abstract from financial frictions or, when they address them, they abstract from financial intermediation. Even when financial intermediation is modeled, the shock that hits the economy in these models often involves an exogenous decline in the net worth of financial intermediaries, thus being very similar to shocks that destroy the economy's capital stock.

This paper goes one step further and addresses this gap. My objective is to develop a tractable framework that studies how disruptions to the flow of resources between agents can act as an exogenous impulse to business fluctuations. To do so, I construct a simple DSGE model where financial intermediaries (banks, for short) amplify and propagate business cycles that are "financial" in nature; that is, they are originated not by changes in technology, but by disruptions in the flow of funds between different group of agents.

When one group of agents pays banks backless than expected, the resulting effect is a loan loss for the bank which causes a reduction in bank capital. As a consequence, the bank can either raise new capital or restrict asset growth by cutting back on lending. If raising capital is di"cult, banks reduce lending. To the extent that some sectors of the economy depend on credit, the reduction in bank credit propagates a recession.

Financial Business Cycles