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

By Federico Giri

http://d.repec.org/n?u=RePEc:anc:wpaper:398&r=dge

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.

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