Does Interbank Market Matter for Business Cycle Fluctuation? An Estimated DSGE Model with Financial Frictions for the Euro Area

April 29, 2014

By Federico Giri

The aim of this paper is to assess the impact of the interbank market on the business cycle fluctuations. We build a DSGE model with heterogeneous households and banks. Two kind of banks are in the model: Deficit banks which are net borrowers on the interbank market and they provide credit to the real economy. The surplus bank are net lender and they could choose to provide interbank lending or purchase government bonds.;The portfolio choice of the surplus bank is affected by an exogenous shock that modifies the riskiness of the interbank lending thus allowing us to capture the collapse of the interbank market and the fl y to quality mechanism underlying the 2007 financial crisis.;The main result is that an interbank riskiness shock seems to explain part of the 2007 downturn and the rise of the interest rate on the credit market just after the financial turmoil.

This paper is a nice example of what can be done in introducing some of the complexities of the banking system into an otherwise standard model. In particular, this allows to quantify the importance of various mechanisms. The drawback is that the sheer number of bells and whistles makes it more and more difficult to understand what is going on. We do know the economy is complex, but models are supposed to be abstractions that help us understand reality. To model the interbank market, though, ones needs to include enough complexity that the abstraction is a little bit lost. Still, a very useful model.


Search-Based Endogenous Illiquidity and the Macroeconomy

April 22, 2014

By Wei Cui and Sören Radde

We endogenize asset liquidity in a dynamic general equilibrium model with search frictions on asset markets. In the model, asset liquidity is tantamount to the ease of issuance and resaleability of private financial claims, which is driven by investors’ participation on the search market. Limited resaleability of private claims creates a role for liquid assets, such as government bonds or fiat money, to ease funding constraints. We show that liquidity and asset prices positively co-move. When the capacity of the asset market to channel funds to entrepreneurs deteriorates, the hedging value of liquid assets increases. Our model is thus able to match the flight to liquidity observed during recessions. Finally, we show that investors’ search market participation is more intense in a constrained efficient economy.

From the latest NEP-DGE report, I have selected this paper because I did not know it was possible to obtain endogenous asset liquidity. Money search has shown us that demand for a very liquid asset can emerge, but it is only a dichotomous choice. In this paper, The liquid asset is always present, and the demand for the illiquid one varies, and as the market for theses illiquid ones is modeled as a search process, its liquidity depends on market participation. Liquidity is thus endogenous, and it matters.

Social Security and the Interactions Between Aggregate and Idiosyncratic Risk

April 9, 2014

By Daniel Harenberg and Alexander Ludwig

We ask whether a PAYG-financed social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household’s life-cycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of 2.2% of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks.

This is an interesting paper that highlights that an important benefit of a social security system is not only coming from the insurance against lifecycle income risk, individual or aggregate, but majorly from the interaction of such indvidual and aggregate risks. And this paper does not even consider the advantage of insuring against longevity risk.