Financial Frictions and Macroeconomic and Financial Policy

Abstract

This thesis is an attempt to study macroprudential policy with models consisting of multiple utility maximising agents. Over the past two decades, many theoretical macro models have been developed studying various aspects related to financial frictions and macroprudential policy. However, not many papers consider the financial sector as utility maximising agents, which makes it difficult to evaluate the direct impact of monetary and macroprudential policy on this sector. This thesis examines two such models and evaluates aggregate and sectoral effects of macroprudential policy implemented with dynamic bank capital adequacy requirements. In chapter 2, we compare the implications of macroprudential policy within a Dynamic Stochastic General Equilibrium (DSGE) model with three utility maximising agents, including bankers, under a real business cycle environment as opposed to a sticky price environment. We use the benchmark model of Iacoviello (2015) with households, entrepreneurs and bankers for this purpose after augmenting it by adding price rigidity to allow for monetary policy, and a bank capital requirement rule to examine macroprudential effects. Rubio and Carrasco-Gallego (2016, 2017) also use similar models, under sticky price and real business cycle environments, respectively, but in separate papers and use different macroprudential rules, thereby making comparison difficult. Our work differs from these contributions as we compare the effects under a real business cycle model and a sticky price model within the same broader model set-up, and because of model differences, such as our model comprising only entrepreneurial borrowings while the former comprising only household borrowings. We find that introducing a macroprudential policy rule stabilises the economy by reducing the volatility of output during financial and productivity shocks, whereas this is not necessarily true during monetary policy shocks. These effects are found to be more pronounced in a real business cycle model than in a sticky price model, implying that the effects of macroprudential policy may be overstated when evaluated in a real business cycle model. Despite its stabilisation effects, macroprudential policy increases the dispersion among the three agents as measured by the volatility in individual consumptions. In particular, during financial and productivity shocks, macroprudential policy results in the consumption of households and entrepreneurs becoming more stable at the expense of bankers' consumption, which becomes more volatile. However, during financial shocks, this trade-off seems less pronounced than following productivity shocks, as macroprudential policy seems to be more effective during financial shocks. These distributional effects hold both in the real business cycle model and in the sticky price model. In chapter 3, we develop and estimate a DSGE model where the focus is on the welfare effects that macroprudential policy has on three utility maximising agents: households, entrepreneurs and bankers. The model assumes real, nominal and financial frictions, stochastic growth shocks and an endogenous default probability of borrowers. The model is estimated to quarterly US data, and then it is used to evaluate the sectoral welfare effects of introducing macroprudential policy. We find that optimal macroprudential policy improves aggregate welfare with respect to standard optimal Taylor rules, as found elsewhere in saver-borrower welfare models. However, we also find asymmetric welfare effects for the three sectors considered here, that are not detectable in the bulk of the saver-borrower macroprudential literature. In times of financial shocks, macroprudential policy results in welfare losses for the bankers, but this is shown to be welfare improving for the aggregate economy as a whole. Further, the benefits of macroprudential policy are found to be increasing the higher are the contribution and volatility of financial shocks.

Date of Award	31 Dec 2019
Original language	English
Awarding Institution	The University of Manchester
Supervisor	George Bratsiotis (Supervisor) & Michele Berardi (Supervisor)