Banks, Credit Market Frictions, and Business Cycles

Abstract The current financial crisis highlights the need to develop DSGE models with real-financial linkages and an active banking sector. This paper proposes a fully micro-founded framework that incorporates optimizing banks, the interbank market, and the credit market into a DSGE model, and evaluates the role of banks and financial shocks in the U.S. business cycles. We assume two types of heterogenous banks that offer different banking services and interact in an interbank market. Loans are produced using interbank borrowing and bank capital subject to the bank capital requirement condition. Banks have monopoly power, set nominal deposit and prime lending rates, choose their portfolio compositions and their leverage ratio, and may endogenously default on fractions of their interbank borrowing and bank capital returns. The model also includes financial and unconventional monetary policy shocks. The main findings are that: (1) The model captures the key features of the U.S. economy; (2) bank behavior substantially affects credit supply conditions and the transmission of different shocks; (3) the banks’ leverage ratio is procyclical; and (4) financial shocks have significant effects on the U.S. business cycle fluctuations, while unconventional monetary easing policies may reduce the negative impacts of the financial crisis.