Efficiency wage theories propose that higher levels of pay induce higher productivity from workers. This argument explains an apparent anomaly in the labor market where some firms pay above-market clearing wages, even when individuals with comparable characteristics to those employed remain involuntarily unemployed. Proponents of these theories argue that cutting wages to market-clearing levels would decrease the productivity of their employees and would result in a higher “labor cost per efficiency unit” (Yellen 1984).
Some efficiency wage theories explain this phenomenon based on the workers’ desire to maximize their own gains. For example, the “shirking model” suggests that above-market wages can induce employees to work harder rather than shirk, due to the greater costs associated with losing their jobs (Shapiro and Stiglitz 1984; Dickens, Katz, Lang, and Summer 1989). Other theories adopt a sociological perspective (e.g. the “gift exchange” and “reciprocity” models), where the positive relationship between relatively higher wages and employee productivity is explained by fairness and reciprocity considerations. In particular, these models predict that employees who believe they are paid more than what they consider to be fair (e.g. more than the pay received by a comparable set of employees in a competing firm) will reciprocate to the firm by increasing their performance, but employees who believe they are paid unfairly (e.g. below-market wages) may reduce their performance and even harm the company “in the name of fairness” (Akerlof 1984; Akerlof and Yellen 1990; Fehr and Gachter 2000).
The strong shift of private savings towards the stock market suggested that the 1990ps boom in consumption was financed by heavily relying on stock market performances. Looking at the U.S., between 1995 and 2000 equity prices rose by about 200% while stock market capitalization as a share of GDP went from 76 to 180. A similar growing pattern characterized the ratio of equity holdings to total financial wealth in house holds portfolios, which steadidy rose from 13% in 1985 to the peak level of 28% just before the early 2000 stock market crash. The Federal Reserve appeared then seriously concerned about the links between financial and real stability, as well as the perils that irrational exuberance might have exerted over consumer and investor confidence and thereby on real activity. In this context, a lively debate started in the economic literature aimed at defining the appropriate response of monetary policy to large swings in stock prices.
The financial accellerator model of Bernanke and Gertler (1999,2001) is probably the most prominent example of a fully fledged DSGE model with supply side linkages between the macroeconomy and the financal market. However, while it captures a quantitatively significant component of aggregate fluctuations due to credit market distortions, this framework remains completely silent on the demand side channel on which the Fed itself expressend some concern. As a matter of fact, there have been very few attempts to model the wealth effects on consumption coming from financial assets in DSGE environments. Notable exceptions are Iacoviello (2005), Iacoviello and Neri (2008) and Monacelli (2008). However, their analysis confines to the role of durables as collaterals and their implications for monetary policy, without any mention of stock market wealth.
There has been a strong interest in understanding interactions between bank capital regulation and macroeconomic fluctuations among policy makers and academic researchers. The interest has become even stronger in the aftermath of the recent financial crisis. One of the key concerns, especially from a macroeconomic perspective, is that bank capital regulation can induce significant “procyclicality,” meaning that bank capital regulation can amplify the macroeconomic fluctuations. The procyclical effect was recognized under the first bank capital regulation, i.e., Basel I, in which banks are required to hold a constant fraction of equity. The procyclicality issue has received significantly more attention under the so-called risk-sensitive regulation (Basel II). Under Basel II, the risk weight associated with each loan is negatively related to the borrower’s credit quality; therefore, during an economic down-turn when overall credit quality deteriorates, capital requirements become more stringent. This further limits banks’ lending capacity. Our interest is to quantify the procyclical effects using a general equilibrium macroeconomic model.
There are many papers with similar interests. Blum and Hellwig (1995) examine the procyclical effects of fixed capital requirements under Basel I. Using a simple reduced-form macroeconomic framework, they argue that it is likely to amplify macroeconomic fluctuations. Heid (2007) goes one step further by studying the implications of risk-sensitive capital requirements in a similar reduced-form environment. More recently, Zhu (2008) studies the effects of bank capital regulation on banks’ behavior by applying the industry model of Cooley and Quadrini (2001) to a banking sector that is subject to risk-sensitive capital requirements. Finally, Repullo and Suarez (2009) develop a micro-founded partial equilibrium model of relationship banking and analyze the banks’ behavior under risk-sensitive capital requirements. They show that the procyclicality under Basel II can be sizable.
