Ebook Short run and long run effects of banking in a New Keynesian model
The current financial crisis has triggered the need for a reformulation of the New Keynesian model in a way that incorporates banking elements. Very recent papers such as Cúrdia and Wood ford (2009), De Fiore and Tristani (2009), and Nolan and Thoenissen (2009) examine the implications of adding a financial sector to the New Keynesian model. Also very recently, the Journal of Monetary Economics has devoted two entire special issues to papers that study the financial crisis: the July 2009 issue, Distress in Credit Markets: Theory, Empirics, and Policy, and the January 2010 issue, Credit Market Turmoil: Implications for Policy. Earlier (and visionary) works by Goodfriend and McCallum (2007) and Christiano, Motto and Rostagno (2008) already discussed the introduction of financial aspects in the New Keynesian models months before the start of the financial crisis.
Most of these papers have in common the hypothesis of the financial accelerator that was put forth a decade ago in the seminal paper by Bernanke, Gertler and Gilchrist (1999). The financial accelerator provides a connection between the financial sector and the real sector. It assumes that the amount of loans is positively affected by the level of collateral available in the economy (bonds and the stock of capital). In good times, the value of collateral tends to rise and banks produce more loans which reduces the external finance premium and provides better opportunities for purchases of consumption and investment goods. By contrast, when the economic scenario turns gloomy the value of collateral is likely to drop and banks reduce the amount of loans because the external finance premium rises. If that reaction of the banks is severe the economy may enter a credit crunch situation like the one observed in 2008 2009. Therefore, the financial accelerator amplifies business cycle fluctuations.
This paper is another contribution to the literature on the extension of the New Keynesian models to incorporate a financial sector and banking elements. Thus, we borrow the model structure developed by Good friend and McCallum (2007), that hinges its banking elements in the financial accelerator of Bernanke et al. (1999), and incorporate two novel features. First, there will be variable capital accumulation in contrast with the constant capital case assumed in Good friend and McCallum (2007). Secondly, the deposit in advance requirement that households must face in their optimizing program includes total spending on consumption goods and also a partial spending on investment goods. Actually, our model introduces a r parameter, that takes a value between 0 and 1, to determine the fraction of investment purchases that must be backed with deposits. The setup of Good friend and McCallum (2007) corresponds to the particular case in which r / because they only put consumption goods in the deposit in advance requirement.
This paper is another contribution to the literature on the extension of the New Keynesian models to incorporate a financial sector and banking elements. Thus, we borrow the model structure developed by Good friend and McCallum (2007), that hinges its banking elements in the financial accelerator of Bernanke et al. (1999), and incorporate two novel features. First, there will be variable capital accumulation in contrast with the constant capital case assumed in Good friend and McCallum (2007). Secondly, the deposit in advance requirement that households must face in their optimizing program includes total spending on consumption goods and also a partial spending on investment goods. Actually, our model introduces a r parameter, that takes a value between 0 and 1, to determine the fraction of investment purchases that must be backed with deposits. The setup of Good friend and McCallum (2007) corresponds to the particular case in which r / because they only put consumption goods in the deposit in advance requirement.
This second exercise will provide information about the long run effects of banking elements on capital, output, consumption or welfare. The rest of the paper is organized in seven more sections. The description of the model and the derivation of its dynamic equations are respectively done in Sections 2 and 3. A comparable model with no banking elements (frictionless finance economy) is introduced in Section 4. The calibration of the parameters is carried out in Section 5 and it is used in Section 6 to compute the impulse response functions and discuss the results for the business cycle analysis of the short run. Section 7 is devoted to the long%run analysis by examining the implications of alternative banking scenarios for the steady state solution of the model. Finally, Section 8 reviews the main conclusions reached in the paper.
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