By Daniel Sanches
http://d.repec.org/n?u=RePEc:fip:fedpwp:17-20&r=dge
This paper develops a dynamic general equilibrium model with an essential role for an illiquid banking system to investigate output dynamics in the event of a banking crisis. In particular, it considers the ex-post efficient policy response to a banking crisis as part of the dynamic equilibrium analysis. It is shown that the trajectory of real output following a panic episode crucially depends on the cost of converting long-term assets into liquid funds. For small values of the liquidation cost, the recession associated with a banking panic is protracted as a result of the premature liquidation of a large fraction of productive banking assets to respond to a panic. For intermediate values, the recession is more severe but short-lived. For relatively large values, the contemporaneous decline in real output in the event of a panic is substantial but followed by a vigorous rebound in real activity above the long-run level.
Hmm, Daniel Sanches is onto something here. Could the high level of financial development be the reason it took so long for the United States to get out of the last banking crisis? Eyeballing the graphs, it looks like the total cost of a banking crisis recession is higher if liquidation is less costly. That seems to be a surprising and counter-intuitive result, as large financial frictions seem to be better. And I wonder whether the steady-state effect of liquidation costs is stronger than the cyclical effect. So many questions…
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