Essays on the financial sector and macroeconomic policy
De Groot, Oliver Vizetelly
University of Cambridge
Faculty of Economics
Doctor of Philosophy (PhD)
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De Groot, O. V. (2013). Essays on the financial sector and macroeconomic policy (Doctoral thesis). https://doi.org/10.17863/CAM.11728
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This thesis is comprised of four self-contained chapters. Chapters 1 and 2 examine, within a DSGE framework, the role of the financial sector in amplifying and propagating business cycles fluctuations in the macroeconomy and the role for macroeconomic policy. Chapter 3 deals with computational issues, and develops in more detail a part of the solution technique used in Chapter 2. Chapter 4 shifts towards the market for government bonds and examines whether fiscal policy reacts to changes in the cost of public debt finance. The four chapters share an overarching motivation, namely having all been motivated by the events of the current financial crisis - first in its guise as a banking crisis and then in its guise as a sovereign debt crisis. All four chapters make a contribution to the literature, whether it is to deepen the understanding of financial frictions models, how they behave, how to solve them and what the policy implications are, or whether it is to expand empirical evidence on fiscal policy behavior. Chapter 1, "Coordination Failure and the Financial Accelerator" studies the effect of liquidity problems in markets for short-term debt within a DSGE model with leveraged borrowers. Creditors (financial intermediaries) receive imperfect signals regarding the profitability of borrowers (entrepreneurs) and, based on these signals and their beliefs about other intermediaries' actions, choose between rolling over and foreclosing on the debt. Due to the uncoordinated actions of intermediaries, the incidence of rollover is suboptimal, generating endogenous capital scrapping and an illiquidity premium on external finance. As entrepreneurs become more leveraged, the magnitude of the coordination inefficiency increases as do the premiums paid on external finance. The interaction between entrepreneurial leverage and the illiquidity premium generates significant amplification of technology shocks, and predicts that periods of illiquidity in credit markets can generate sharp contractions in output. Two unconventional policy responses are analyzed. Dire.et lending to entrepreneurs is found to dampen output fluctuations. Equity injections into entrepreneurs' balance sheets, however, are significantly more powerful in dampening the contemporaneous effect of illiquidity shocks, but cause output deviations from potential to persist. Chapter 2, "The Risk Channel of Monetary Policy" examines how the design of monetary policy effects the riskiness of financial institutions aggregate portfolio structure, a mechanism referred to as the risk channel of monetary policy. I study the risk channel of moneta1y policy in a DSGE model with nominal frictions and a banking sector that has the option to issue outside equity as well as short term debt, making bank risk exposure an endogenous choice, and dependent on the (monetary) policy environment. The portfolio choice of the banks is determined by solving the model around its risky steady state. I find that banks reduce their reliance on short-term debt and decrease leverage when monetary policy shocks and prevalent. A monetary policy Taylor rule that reacts to movements in leverage in the banking system or to movements in credit spreads, incentivizes banks to increase their use of short-term debt funding and increase leverage, ceteris paribus, increasing the risk exposure of the financial sector for the real economy. The chapter finishes by searching for the optimal simple monetary policy rule in this environment. Chapter 3, "Computing the Risky Steady State in DSGE Models" describes a simple procedure for solving the risky steady state in medium-scale macroeconomic models. This is the "point where agents choose to stay at a given date if they expect future risk and if the realization of shocks is Oat this date" Coeurdacier, Rey, and Winant (2011) . This new procedure is a direct method which makes use of a second-order approximation of the macroeconomic model around its deterministic steady state, thus avoiding the need to employ an iterative algorithm to solve a fixed point problem. The methodology advanced in this chapter is used in Chapter 2. Chapter 4, "Cost of Borrowing Shocks and Fiscal Adjustment", based on joint work with Federic Holm-Hadulla and Nadine Leiner-Killinger, examines whether capital markets impose fiscal discipline on governments. We investigate the responses of fiscal variables to a change in the interest rate paid by governments on debt using a panel of 14 European countries over several decades. This is done in the context of a panel vector autoregressive (PVAR) model, using sign restrictions via the penalty function method of Mountford and Uhlig (2009) to identify structural cost-of-borrowing shocks. Our baseline estimation shows that a one percentage point rise in the cost of borrowing leads to a cumulative expansion of the primary balance-to-GDP ratio of approximately 1.9 percentage points over 10 years, with a fiscal response only significantly evident two years following the shock. We also find that the majority of fiscal adjustment takes place via a rise in government revenue rather than a cut in primary expenditure. The size of the total fiscal adJ'ustment ~ ' however, is insufficient to avoid the gross government debt-to-GDP ratio from rising as a consequence of the shock. Sub-dividing our sample we also find that the EMU countries post-1992 (the year of the Maastricht Treaty) raised thei primary balances more aggressively in response to a cost-of-borrowing shock than they did prior to 1992.
This record's DOI: https://doi.org/10.17863/CAM.11728