Ebook International Real Business Cycles: Are Countercyclical Margins in Banking the Missing Transmission Mechanism?
A significant amount of research in international macroeconomics has been devoted to answer the question of what are the channels through which business cycles are transmitted across countries. Unfortunately and despite all this work, there is still no consensus on what determines business cycle comovement.
There are also important discrepancies between the data and what standard models predict regarding the international comovement of macroeconomic aggregates. These discrepancies were first identified by Backus, Kehoe and Kydland (1992) for the OECD countries. They have been labelled “anomalies” when proved robust to various changes to parameter values and model structures. The discrepancies are two. First, in the data, correlations of output across countries are larger than analogous correlations for consumption. With only a few exceptions, previous work obtains consumption cross-country correlations that significantly exceed output correlations. This inconsistency has been labelled the “consumption/output anomaly” or the “quantity anomaly”. Second, investment and employment comove across countries in the data, while most models predict negative values for their cross-country correlation. Many candidates have been suggested to propose a solution to these puzzles, but no agreement has been reached on what is the best way to solve them.
The goal of this paper is to study the international transmission of business cycles and to propose a potential solution to these anomalies. To do so, I extend an otherwise standard two-country dynamic stochastic general equilibrium model in two ways: I allow for trade in two different goods, and I model a novel type of friction in the market for bank credit.
Having two goods with each country specializing in the production of one of them provides a “demand channel” and a “terms of trade channel” to the international transmission of productivity shocks. When a positive shock hits one of the countries, the other faces an increased demand for the good it produces, and some of the benefits spill over to the latter. Also, terms of trade change and imply a positive wealth effect for the country where productivity is not exogenously affected. These features of the model are consistent with the recent empirical results in Baxter and Kouparitsas (2005), who show that bilateral trade is the only robust variable in explaining comovements.
However, previous work has shown that having trade in two goods is not enough to account for the positive correlation of macroeconomic aggregates across countries. In models with perfectly functioning credit markets and no exogenous restrictions to capital mobility, capital would flow from the rest of the world into the country where productivity is relatively higher. This gives rise to the negative cross-country correlations of factors of production, to the very low cross-country output correlations and to the perfect consumption correlations generally obtained in theoretical models. Financial imperfections prevent capital from flowing from the rest of the world into the relatively more productive economy, and help to get cross country comovement for investment, employment and output. However, it has been shown that modelling incomplete financial markets (by allowing agents to have access to only a risk-free bond) and/or adjustment costs to investment is not enough to replicate the transmission of business cycles observed in the data.
Therefore, in this paper I also model a novel type of credit market friction through the introduction of a non-competitive banking sector and endogenously cyclical price-cost margins in the market for loans. Modelling imperfect competition in the financial sector is something to my knowledge not previously done in the context of the international RBC literature. I argue in this paper that countercyclical price-cost margins in banking are a key missing transmission mechanism in this literature that can explain the comovement of business cycles. Section 5 elaborates on how counter cyclical margins become a key transmission mechanism needed to account for business cycle comovement.
This mechanism also has strong empirical support. Aliaga-D?az and Olivero (2005), Chen, Higgins and Mason (2005) and Mandelman (2005) present empirical evidence on the countercyclical behavior of banks’ price-cost margins. Empirical work also provides support to the imperfectly competitive behavior of banks in OECD countries. Nathan and Neave (1989) provide evidence for imperfect competition in the Canadian banking sector. Neven and Roeller (1999) study European loan markets and find significant evidence of market power in both the corporate loan and the household mortgage markets. Bikker and Haaf (2002) and Claessens and Laeven (2003) use the H statistic to measure contestability for a cross-section of countries, obtaining values consistent with imperfect competition.
Imperfect competition in banking also produces a novel financial accelerator coming from the supply side of the loans market. Alternative to the Bernanke and Gertler (1989) financial accelerator, here it is the degree of market power in banking changing over the business cycle what can make credit spreads countercyclical. This has interesting policy implications due to its macroeconomic impact. With margins in the market for credit being countercyclical, credit becomes more expensive in bad times relative to standard models. If firms are heavily reliant on credit to finance investment, they may delay their investment and production decisions further and the recession may be made deeper and longer. This in turn may provide additional support to stabilization policies in economies where these margins are countercyclical.
Several papers have looked at various determinants of the international transmission of business cycles and tried to explain the anomalies. They have done this through adjustment costs to investment, imperfect competition in goods markets, household production of non-tradeable goods, government spending entering preferences and shocks to beliefs among others. In general, they have been relatively unsuccessful in finding a solution to all puzzles simultaneously. Among these papers, my work is most closely related to those using credit market frictions and imperfect competition in goods markets to study the anomalies. They are briefly reviewed in Section 2.
In the calibration exercise I obtain positive cross-country correlations for investment, employment and output when banks’ margins are countercyclical. For some parameterizations, I propose a potential solution to the “quantity anomaly”. I do so while still reproducing the countercyclicality of net exports, another important stylized fact in the RBC literature.
Qualitative results are robust to sensibilizations of parameter values and they indicate that an important link to understand the international transmission of economic activity that has been absent from the previous literature is the cyclical behavior of banks’ price-cost margins. Results are also indicative of the importance of both the “demand channel” and the “terms of trade channel”. Having two goods together with credit market frictions is crucial if one wants to replicate both the comovement of macro aggregates and the countercyclicality of the trade balance.
I proceed as follows. In Section 2 I provide a brief literature review. I present the data stylized facts that the model is intended to reproduce in Section 3. In Section 4 I introduce a model of exogenously time-varying banks’ price-cost margins. I analyze the intuition about the main transmission mechanisms in Section 5, and present the results in Section 6. In Section 7 I endogenize the cyclical behavior of margins. I conclude in Section 8. Appendix A presents the derivation of the interest rate elasticity of the demand for credit by entrepreneurs. Appendix B shows the results for the sensibilization of the parameter that governs the “trade channel”. Appendix C contains some important robustness checks of the model.
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