1 The macroeconomic consequences of nancial imperfections the transmission channels of monetary policy the fragility of the nancial system the existence of nancial cycles the real eects of nancial intermediation 2 The transmissions channels of monetary policy Two dierent views: Money channel essentially asserts that only banks'liabilities (money) matter. The credit channel emphasizes the importance of bank loans, as opposed to other sources of funds 3 Financial fragility Bernanke and Gertler (1990) What is the eect of adverse selection on macroeconomic activity? Could asymmetric information limit credit and economic activity? 3.1 The model Two period (t = 1, 2) general equilibrium model Innite number of risk neutral entrepreneurs and households 1
Agents have access to a riskless (storage) technology Each entrepreneur owns a risky technology : 1 unit of the good at t = 1 becomes X units (at t = 2) with probability p, and 0 with probability (1 p) 3.2 Information structure Adverse selection on p Initial wealth ω of each entrepreneur is publicly observable p is only privately observable by the entrepreneur after a screening which costs him C. After screening the project, if p is large enough, the project is undertaken. Absent screening the project has a negative NPV 3.3 First best allocation Among the projects which are screened, only those with a positive expected excess return will be undertaken (px > 1 + r). This gives the cut-o probability p under which projects are not nanced : (1) p = 1 + r X. Screening will take place (for all projects) if and only if : (2) C < V def = E p [max(0, px 1 r)], which we will assume holds true. As a consequence all projects will be screened. The investment of rms is nanced in part on their own wealth and in part by households' savings, The rest of initial endowments is stored 2
3.4 The eect of asymmetric information (1 ω) will have to be borrowed. The loan contract is completely described by the amount (1 ω) to be lent and the amount R (which will depend on ω) to be repaid in case of success. The characteristics of the contract determine the cut o probability ˆp(ω) chosen by the entrepreneur. It is given by : (3) (X R(ω))ˆp(ω) = rω The equilibrium contract will be determined by this equation jointly with the zero prot condition for lenders 3.5 The eect of moral hazard If the endowment is inferior to ω C the entrepreneur has no incentive to screen the project, and therefore there will be credit rationing. 3.6 Macroeconomic implications The global performance (output q and investment I) of this economy does not only depend on the fundamentals of investment (i.e. p, µ, V and C) but also on the nancial situation of rms (captured here by the distribution of their initial wealth ω). Firms' low prots imply that investment and output will be low even if the fundamentals are good. This situation is described by Bernanke and Gertler as nancial fragility. Moreover entrepreneurs with a ω lower than ω C will not be granted credit. There will be a collapse of investment due to the poor nancial condition of rms. 4 Financial cycles and uctuations Are business cycles and economic uctuations amplied by nancial markets, constraints and imperfections? 3
4.1 Credit cycles Kiyotaki and Moore (1995) consider an economy in which credit cycles appear because of two ingredients :loans are fully collateralized and the price of collateral uctuates. When loans are collateralized, the amount borrowed is determined by the future value of collateral : a decrease in the future price of collateral has a negative impact on today's investment. 4.1.1 The model There are only two goods : a non storable physical good used for consumption and production, and a capital good (real estate) used as collateral by borrowers and also as a productive asset. There are two classes of agents : entrepreneurs who own productive asset (land), and lenders who are endowed with the consumption good. Entrepreneurs have to borrow against collateral all the consumption good they invest in their projects. The technology is of the Leontie type with constant returns to scale and requires one period. There is an alternative use for land such as residential real estate. The price of land today is determined by a no arbitrage condition. It is a function of its price tomorrow and its protability given the credit it allows to obtain and the rental activity prots. Result: nancial cycles may obtain independently of the existence of macroeconomic uctuations. 5 The real eects of nancial intermediation Homstrom-Tirole (1994) 4
Firms have to fund their investment (of xed size I) Moral hazard problem : rms' managers may choose a bad project (with a low probability of success p L ) instead of a good project (with a high probability of success p H ) because the bad project gives them a private benet B. Justication of banks: if the rm is monitored by a bank, at a cost C, this private benet is decreased to b, with b + C < B. The moral hazard problem can be solved without monitoring, if rms have enough cash assets A that they can invest in their projects. This happens when the following condition is satised: M anager Incentives : P articipation Constraint : p H (R R u ) p L (R R u ) + B Sufficient F unding : p H R u ρi u A + I u I But this implies a constraint on the entrepreneur investment in the project. (4) A Ā(ρ) = I p H ρ R u If (6) is not satised, the moral hazard problem may be solved by bank lending. A bank lends I m to the rm, which is nanced partly by its own funds and partly by borrowing I I m A on the nancial markets. This happens when A(β, ρ) A < Ā(ρ) 5
where β denotes the gross return on bank loans and is determined by the equilibrium equation of the market for banking capital : (5) K m = [G(Ā(ρ)) G(A(β, ρ))]i m(β). Here G is the distribution function of the rms' assets A, and I m (β) equals the portion of each loan which is nanced by the bank's own wealth. The interest rate for uninformed funds (bonds, deposits) ρ is determined by the equilibrium condition on the nancial market total savings equal total investments: This framework allows to analyse three types of nancial shocks : a credit crunch (the capital of the banking industry,k m, decreases) a collateral squeeze (negative, shock on rms' assets) and a savings squeeze (ρ increases). Holmstrom and Tirole obtain the following result: A credit crunch decreases ρ and increases β A collateral squeeze decreases ρ and β A savings squeeze increases ρ and decreases β. 6