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6 TheMacroeconomicConsequencesofFinancialImperfections
Itmayseemstrangetodevoteachapterofthisbooktomacroeconomicissues,sincethediscussionsofarhasfocusedexplicitlyonthemicroeconomicapproachto bankingandhasessentiallyignoredthetraditionaltextbookmaterialonmoneyandbankinginmacroeconomicequilibrium.Nevertheless,thelasttenyearsorsohave witnessedapartialrejectionofthistraditionalmaterial.Thistrendistheresultofthepromisingdevelopmentoftheoreticalliteratureonthemacroeconomicimplications ofthesamefinancialimperfectionsthatarestudiedindetailinthisbookandthathavebeenusedtoexplaintheroleofbanksandfinancialintermediaries(seeGertler 1988forafirstoverview).Althoughthistheoreticalliteraturehasnotreallystabilizedyet,inparticularbecauseithasnotbeenconvincinglysupportedbyempirical evidence,itisimportanttobeawareofsomeofitsresults. Afterashorthistoricalperspectiveonthemacroeconomicconsequencesoffinancialmarkets'imperfections(Section6.1),thischapterwillstudyfiveissues: 1.Thetransmissionchannelsofmonetarypolicy(Section6.2) 2.Thefragilityofthefinancialsystem(Section6.3) 3.Theexistenceoffinancialcycles(Section6.4) 4.Therealeffectsoffinancialintermediation(Section6.5) 5.Theimpactoffinancialintermediationongrowth(Section6.6). 6.1AShortHistoricalPerspective InthefirstissueofEconometrica,IrvingFisher(1933)arguedthattheseverityoftheeconomicdownturnduringtheGreatDepressionresultedfromthepoor performanceoffinancialmarkets.Hedefinedtheconceptofdebtdeflation:whenborrowers(firms)arehighlyleveraged,asmallshockthataffectstheirproductivity ortheirnetwealthcantriggeraseriesofbankruptcies,whichgenerateadecreaseininvestment,indemand,andasaconsequence,inprices.Thisaggravatesthereal indebtednessoftheproductivesector,whichmayprovokeafurtherseriesoffailures,Withacumulativeeffect. ThisviewpointwaslaterreinforcedbytheGurleyShaw(1955)theoryaccordingtowhichfinancialintermediariesplayacriticalroleinfacilitatingthecirculationof loanablefundsbetweensaversandborrowers.AlsoinlinewiththisviewisthefindingbyGoldsmith(1969)thatapositivecorrelationexistsbetweeneconomicgrowth andthedegreeofsophisticationanddevelopmentofthefinancialsector. FollowingthepublicationbyFriedmanandSchwartz(1963)oftheirmonetaryhistoryoftheUnitedStates,theideathatmoneysupplywasthekeyfinancialaggregate gainedwidesupport.FriedmanandSchwartzfoundahigh

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positivecorrelationbetweenmoneysupplyandoutput,especiallyduringtheGreatDepression.Theyarguedthereforethatbanksdidmatterinsofarastheycreate money.ThisisinlinewiththeconclusionsofsimpleIS/LMmacromodels,inwhichthemoneysupplyisassumedtobecontrolledbytheCentralBankmacrucial simplifyingassumption.Infact(asSection6.2willdiscuss),eveniftheCentralBankcancontrolthemoneybase,theothercomponentsofthemoneysupplyadjustto changesininterestrates.Asaconsequence,thestockofmoneyisinfactlessimportantformacroeconomicperformancethanthefinancialcapacityoftheeconomy, definedastheaggregatevolumeofcreditthatlendersarereadytogranttoborrowers.Therefore,inresponsetoFriedmanandSchwartz's''moneyview,''the alternativepositionwastoemphasizethe"creditview." Afterthe1960s,andfollowingModiglianiandMiller's(1958)contribution,theviewthat"financeisaveil"becamewidelyaccepted.Ifthefinancialstructureoffirmsis irrelevant,andiffinancialintermediariesareredundant,thenmonetarypolicycanhaveonlyatransitoryimpactonrealvariables,throughunanticipatedchangesinthe moneysupply.Inalltherealbusinesscyclemodelsthatweredevelopedsubsequently,financedoesnotplayanyrole. Thecomebackoffinancialaspectsinmacromodelsstartedintheearly1980s.FollowinganearlierstudybyMishkin(1978),Bernanke(1983)analyzedtherelative importanceofmonetaryversusfinancialfactorsintheGreatDepression.Hiscentralconclusionwasthatmonetaryforcesalonewere"quantitativelyinsufficient"to explaintheDepression'sdepthandpersistence,andthatthecollapseofthefinancialsystem(halfoftheU.S.banksfailedbetween1930and1933,andthefinancial marketscrashedworldwide)wasanimportantfactor.Therefore,thedeclineinthemoneystockseemsinfacttohavebeenlessimportantthanarguedbyFriedman andSchwartz.Bernanketestedthetwoexplanations(thebreakdowninbankinghavingaffectedborrowerswhodidnothaveaccesstosecuritymarketsversusthe declineinmoneysupply)andconcludedinfavorofthefirst.Thus,thispieceofempiricalevidencegavesupporttothecreditview,whicharguedthatfinancialmarkets appearedtobeimperfect,sotheModiglianiMillerassumptionsdidnotholdandfinancedidmatter. Thefollowingsectionswillstudythedifferenttheoreticalargumentsthatsupportthisview,startingwiththosethataimtoexplainthetransmissionchannelsofthe monetarypolicy. 6.2TheTransmissionChannelsofMonetaryPolicy ItisimportanttorecognizethattheprecisemechanismsthroughwhichthemonetarypolicyofCentralBanksaffectsrealactivityarenotcompletelyunderstood.l Beforediscussingthesemechanisms,andwithoutgoingintoinstitu

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tionaldescriptionsthatareoutsidethescopeofthebook, recallthemainmethodsusedbyCentralBankstosupplyliquiditytothebankingsystem.Althoughthe detailedproceduresdiffer,mostCentralBanksofdevelopedcountriesprimarilyusethesameinstrument,namelyan"auctionofreservesonarepurchasebasisagainst collateralofsecurities"(Schnadt1993,123).Inadditiontotheseoperations,banksarepermitted,ontheirowninitiative,toobtainshorttermadvancesfromthe CentralBank.Ofcourse,thecostoftheseadvancestypicallyexceedstheinterestrateontheregularopenmarketauctionsofreserves.Thisfacilitymaybe systematicallyoffered,asinFranceandGermany,orfrequentlyrationedasintheUnitedStates.Bankreservesarealsotradedonasecondarymarket(theinterbank marketorthefederalfundsmarketintheUnitedStates).Finally,awidersetofmarketsforliquidity(thesocalledmoneymarket)existsinwhichotherfinancial institutionsandlargenonfinancialfirmsintervene. Roughlyspeaking,twodifferentviewsonthemechanismsofmonetarypolicystillcoexistamongeconomists.Themoneyview(presentedinsubsection6.2.1) essentiallyassertsthatonlybanks'liabilities(money)matter.Thecreditview(presentedinsubsection6.2.2)insistsontheimportanceofbankloans,asopposedto othersourcesoffundsforborrowers.Subsection6.2.3willcomparethetwoviewsbyjudgingthepertinenceoftheassumptionstheyrequireandbyexaminingsome empiricalevidence.Finally,subsection6.2.4willdepartfromthestandardmoneymultipliermodelandwillintroducethetopicofendogenousmoney. 6.2.1TheMoneyChannel Initssimplestformulation,themoneychannelcanbedescribedinthestandardIS/LMmodelthatis,inaworldwithonegood,twoassets(moneyDandbondsB) andfourtypesofagents:households,firms,banks,andthegovernment.3Therealincomeofhouseholds(y)andtheinterestrateonbonds(rB)determine(real)savings S(y,rB),whichareallocatedbetweenthetwoassets:

wheresuperscripthreferstohouseholds,and+orindicatesthepostulated signsofpartialderivatives.Similarly,theinvestmentdemandoffirmsI(rB)4isfinancedthroughbonds:

wheresuperscriptfreferstofirms.Themodelingofbanksissimplistic:they issuedepositsDb,purchasebondsBb,andholdreservesR,withthefollowingbalanceconstraint:

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Figure6.1 TheConsequencesofIncreasingReservesintheIS/LMModel

Inthesimplerstory,banksarecompletelypassive.BbandDbaredeterminedbythereserveratearequiredbytheCentralBank(R=a Db),implying

Finally,thelastagentisthegovernement,whichfinancesrealexpendituresGbythereservesRborrowedfrombanksandbyissuingbondsBg:

UsingWalras'slaw,twoequationsareenoughtocharacterizetheequilibriumlevelsoftheendogenousvariablesyandrB:

(equilibriumonthemoneymarket)and

(equilibriumonthegoodsmarket). Undertheassumptionsregardingthesignsofpartialderivatives,thetraditionaltextbookanalysisoftheKeynesianmodelisobtained,inwhich6.6and6.7correspond respectivelytotheLMandIScurves. Theeffectofmonetarypolicyisthenclearcut:iftheCentralBankincreasesRordecreasesBg(liquidityinjection),5theLMcurvemovesdownward(seeFigure6.1), buttheIScurveisunaffected.Therefore,activityisenhanced(yincreases)andtheinterestratedecreases. Theimplicitassumptionsthatareneededforthisanalysistoholdareasfollows:

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A1:Pricesdonotadjustinstantaneouslytooffsetchangesinthe(nominal)quantityofmoney. A2:TheCentralBankcandirectlyinfluencethenominalquantityofmoneybyadjustingreserves.
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A3:Loansandbondsareperfectsubstitutesfortheborrowers(therefore,explicitlyintroducingbanksisunnecessary). ThefollowingdiscussionwillexplorewhathappensifassumptionsA2andA3aremodified. 6.2.2CreditView FollowingBernankeandBlinder(1988)(seealsoBernankeandBlinder1987),thepreviousmodelwillbemodifiedbyintroducingbankloansasanimperfect substituteforbonds.6TheinterestrateonbankloansisdenotedrL.Thebehaviorofhouseholds(equation6.1)isnotmodified,butthatoffirmsandbanksisnow morecomplex.Firmshavenowtwopossibilitiesforfinancingtheirinvestments,sothat6.2isreplacedby

Similarly,banksnowhavethreeassets(reserves,loans,andbonds),so6.3isreplacedby

Asbefore,thequantityofmoneyisexogenouslydeterminedbythemultipliermechanism: notexplicitlymodeledbyBernankeandBlinder):

bybanksresultsfromtheirportfoliooptimization(whichis

with systemoftwoequations:

.Themoneymarketequilibrium(equation6.6,LMcurve)isthesameasbefore,butequation.6.7(IScurve)hastobereplacedbya

(equilibriumonthegoodsmarket)and

(equilibriumonthecreditmarket).

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Usingtheassumptionsregardingthesignsofpartialderivatives,equation6.12canbesolvedforrL:
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Injectingequation6.13in6.11yieldswhatBernankeandBlindercallthecommoditiesandcredit(CC)curve:

ThemaindifferencebetweenthecurrentandthepreviouscaseisthatRappearsintheCCcurvebutwasabsentfromtheIScurve.Thefollowingresultisobtained: Result6.1 AnincreaseinbankreserveshastwoeffectsintheBernankeBlindermodel: 1.Asinthepreviouscase,thequantityofmoneyincreases(theLMcurveshiftsdownward). 2.Inaddition,thevolumeofcreditincreases,whichenhancesthedemandforinvestmentbyfirms(theCCcurveshiftsupward). Asaresult,activityisenhanced(yincreases)buttheeffectonrBisambiguous.7 Proof TheproofisobviousfromFigure6.2.

Figure6.2 TheCreditChannelofMonetaryPolicy

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AfirstimportantconsequenceofthisresultisthatmonetarypolicycanhaveimportantrealeffectswithoutsubstantiallyaffectingtheinterestraterB.Ifbankshavemore accesstoreserves,theycanincreasetheircreditsupplytofirms,whichcaninturninvestmorewithoutsignificantlychangingtheirdemandforbonds.
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Asecondimportantconsequenceconcernstherelevanceofmonetarypolicyindicators.IftheCentralBankcannotdirectlyandinstantaneouslyobservetheimpactof itspolicyonrealactivitybuthastorelyonfinancialindicators(money,interestrates,andcredit)thequestionis,whichofthesefinancialvariablesgivesthebest forecastofrealactivityandshouldthereforebeusedasatarget?Inthemoneyview,allthreevariablesareperfectlycorrelated.Inthecreditview,creditshouldbethe target.Thefollowingdiscussionwillfocusontherelevanceoftheassumptionsthatareimplicitinthecreditviewandtheempiricalworkonthequestion,closely followingKashyapandStein(1993). 6.2.3CreditViewversusMoneyView:RelevanceoftheAssumptionsandEmpiricalEvidence Theimplicitassumptionsbehindthecreditviewareasfollows:8 A1:Pricesdonotadjustinstantaneouslytooffsetchangesinthe(nominal)quantityofmoney. A'2:TheCentralBankcandirectlyinfluencethevolumeofcreditbyadjustingbankreserves. A'3:Loansandsecuritiesareimperfectsustitutesbothforborrowersandforbanks. AssumptionA1iscommontobothviewsofmonetarypolicy.TheearlyexplanationsofA'2(thesocalledavailabilitydoctrineofRoosa1951)reliedoncredit rationing.Modernarguments(relatedtoimperfectinformationandthemonitoringroleofbanks)explaintheassumptionwithoutcreditrationing:asChapter2showed, firmshavinginsufficientcapitalorreputationcannotissuedirectdebtandthereforerelyoncreditfromfinancialintermediaries.Thisisconfirmedbyempiricalevidence: James(1987)showsthatbankcreditismoreexpensivethandirectdebt,whichindicatesthatthereis"somethingspecial"inbankservicestoborrowers.Similarly, Hoshi,Kashyap,andScharfstein(1991)showthatJapanesefirmswithclosebankingtiesarelesslikelytobeliquidityconstrained.However,aspointedOutby KashyapandStein(1993),financialintermediariesotherthanbanks(suchasfinancecompanies,whichdonotholdcentralBankreserves)could.inprincipleprovide thesameservices.Evenifthesenonbankintermediariesdonotappeartohavealargeshareofthecreditmarket,theycouldeffectivelybethe"marginal"lendersinthe economy,whichwouldsupplycredittotheeconomywhentheCentralBankrestrictsliquidity,thusunderminingassumptionA'2.Thisdoesnotseemstobethecase, probably

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becauseofthe"lockin"effect(Sharpe1990,Rajan1992,andSlovin,Sushka,andPolonchek1993):becauseofinformationalasymmetries,borrowerscannotswitch fromonelendertoanotherwithoutcost.
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However,onemaywonderwhetherinthefuture,nonbankscoulddrivedepositoryinstitutionsoutofthecreditmarket,implementingeffectivelyanarrowbanking solution.AsGortonandPenacchi(1990)argue,thisisconceivable,since"thesumofoutstandingTreasurybillsandnonfinancialcommercialpaperisnow(intheUS) roughlytwiceaslargeasthelevelofcheckablebankdeposits"(quotedbyKashyapandStein1993,18). Finally,evenifoneacceptstheviewthatloansandsecuritiesarenotperfectsubstitutesforborrowers,theycouldbeviewedassuchbybanks.Forinstance,Romer andRomer(1990)arguethatthesupplyoflargedenominationCertificatesofDeposits(CDs)(whicharenotsubjecttoreserves)addressedtoanygivenbankis perfectlyelasticatthecurrentmarketrate.However,thisisnotconfirmedbycasualempiricism:anonnegligibleinterestspreadexistsbetweenCDsandTreasurybills (Tbills)ofthesamecharacteristics.Moreover,thesespreadsappeartobestronglydependentonthebanks'ratingsgivenbytheratingagencies.CookandRowe (1986)(quotedbyKashyapandStein1993)givetheexampleofContinentalIllinois,whichexperiencedalargeincreaseinitsCDratesbeforegoingbankrupt. Anotherexplanationfortheimperfectsubstitutabilitybetweenloansandsecurities(hereessentiallyTbills),documentedbyBernankeandGertler(1987),isthatbanks useTbillsasabufferagainstliquidityshocks.ThisisconfirmedbythefactthatlargebanksholdsignificantlyfewerTbillsthantheaverage(KashyapandStein1993, 20). Thisdiscussionwillconcludewithalookatsomeempiricalworkonthesubjectofthecreditviewversusthemoneyview.Strongevidenceseemstoexistinfavorofa highcorrelationbetweencreditsupplyandeconomicactivity.Asalreadymentioned,Bernanke'sinfluentialstudyoftheGreatDepressionintheUnitedStates(1983) attributesitsdepthandpersistencetothecrisisexperiencedbytheU.S.bankingsectoratthattime.Similarconclusionsareobtainedforotherperiodsandother countries(BernankeandJames1991,Schreft1990,Bernanke1986). Anotherimportantempiricalissueiswhethermonetarypolicyreallyinfluencescreditsupply(assumptionA'2)morethanmoneysupply(assumptionA2).Several studies(King1986,RomerandRomer1990,Ramey1992)havefoundthatloansadjustgraduallytochangesinmonetarypolicybutthatmoneychangesmorerapidly andiscorrelativelyabetterpredictorofoutput.Kashyap,Stein,andWilcox(1993)gofurtherandexaminetheimpactofmonetarypolicyonthecompositionoffirms' borrowing(i.e.,itsrepartitionbetweenbankloansandcommercialpaper).Theyfindthatanepisodeofrestrictivemonetarypolicyistypicallyfollowedbyaraisein commercialpaperissuanceanda

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declineinbankloans.Usingcrosssectionaldata,GertlerandGilchrist(1992)showthatinsuchacaseexternalfinancingoflargefirmsactuallyincreases(both commercialpaperandbankloans)andthatitisthesmallfirmsthatpaytheburden,sincetheyexperiencealargedecreaseinbankloans,whichareessentiallytheir onlysourceofexternalfinance.

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6.2.4EndogenousMoney Thediscussionthusfarhasworkedwithastandard,butcaricatural,descriptionofmonetarypolicy:themoneymultipliermechanism,whichassumesthatthe compulsoryreservescoefficienta isfixed,andthequantityofmoneyintheeconomyiscompletelydeterminedbythemoneybase(i.e.,compulsoryreservesR).As Chapter3showed,thisisnotsatisfactory,foratleasttworeasons: 1.Becausebanks'depositsarenowremuneratedinmostcountries,theirsupplyisnotindependentofinterestratesmoneyisendogenous. 2.Themodeminstrumentsofmonetarypolicyareinterestratesandnotthe monetarybase. ThesetwoaspectswillnowbeintroducedinasimpleextensionoftheBernankeBlindermodelbasedonGrimaud(1994).Themaindifferencesarethatbanking depositsarenowremunerated(ataninterestraterD)andthatbanksareexplicitlymodeledasprofitmaximizers.Forconvenience,thisdiscussionusesthecompetitive modelofthebankingsectordescribedinChapter3(Section3.2)andwillassumeconstantmarginalcostsgDandgL.ofmanagingdepositsandloans.Theequilibrium equationsonthecreditanddepositmarketarethensimply

and

whererdenotestheinterestrateontheinterbankmarket.9Moreover,bankshaveaccesssimultaneouslytothebondmarketandtotheinterbankmarketandbehave competitively.Thus,assumingthatallbanksaresolvent,theinterestratesonthesetwomarketsmustbeequal:

ThefollowingnewexpressionsfortheLMcurveshowhowtheBernankeBlinderresultsaremodifiedbyintroducingendogenousmoney:

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Theonlydifferencebetweenthenewexpressionand6.6isthatthequantityofmoneynowdependsonrD,whichisitselfdeterminedbythedepositmarketequilibrium condition6.16.ThenewexpressionfortheLMcurveistherefore
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NotethatthismodifiedLMcurveisnotnecessarilyincreasinginthe(rB,y)plane.Indeed,differentiating6.18yieldstheslopeofthiscurve:

IfthedemandformoneyisverysensitivetothedepositraterD,thisexpressioncanbenegative,whichmeansthattheLMcurvecanverywellbedecreasing. RecallthesecondconstitutiveelementoftheBernankeBlindermodel,namelytheCCcurve.ThiscurveisobtainedfromtheISequation,

byincorporatingtheequilibriumvaluesofrLandrDasafunctionofrB.NoticethatsavingsnowdependonrD.Thefollowingresultisobtained:

Underthegivenassumptions,thiscurveisdecreasinginthe(y,rB)plane.AnimportantdifferencebetweenthiscurveandtheCCcurveofBernankeandBlinder (equation6.14)isthatthiscurveisindependentofR.Thismodifiestheconsequencesofanincreaseinbankreserves. Result6.2 IfthemodifiedLMcurveisincreasing,thenanincreaseinbankreserves(liquidityinjection)hasthefollowingconsequences: Activityisenhanced(yincreases),andtheinterestrateonbondsrBdecreases. Asaconsequence,interestratesonbothcreditrLanddepositsrDdecrease,andthequantityofmoneyincreases. ThisresultalsoholdstrueassoonastheslopeoftheLMcurve, (thiscanoccurifthedemandformoneyisveryelastictorD),theconsequencesofaliquidity injectionarecompletelyreversed:outputydecreases,andmoneyandinterestratesrB,rL,andrDincrease.Thereason

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isthat,inthiscase,thedemandformoneyissosensitivetothevariationsofrDthatanincreaseinthestockofmoneymeansthatallinterestratesincrease.
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SupposenowthattheCentralBankdeterminestheinterbankraterandthatbankschoosetheirownreserves(accordingtoequation6.18).Thisismoreinlinewith theactualconductofmonetarypolicyinmostcountries.Inthecompetitivemodelofthebankingsector(withconstantmarginalcostsofintermediation),the movementsofallinterestratesareexactlyproportionaltothoseoftheinterbankmarket:

Theimpactofronyisdirectlyobtainedfrom6.20:

Inparticular,adecreaseinrisalwaysfollowedbyanincreaseinoutputy.However,theimpactonmoneyisambiguousitdependsonthesignoftheslope.of . 6.3TheFragilityoftheFinancialSystem Thetwoarticlesthatwillbepresentedinthissectionexaminetheconditionsunderwhichaneconomymayexperienceabrutalcontractionofcreditand,asa consequence,ofactivity.Ineachcase,thisphenomenonisrelatedtoasymmetricinformation.Subsection6.3.1willdiscussthesimplermodelofMankiw(1986),in which,becauseofadverseselection,thecreditmarketmaycollapseafterasmallincreaseinthemoneymarketrate(whichisthecostofbanks'refinancing). Subsection6.3.2willthenstudythecontributionofBernankeandGertler(1990),whoshowthat,becauseofmoralhazard,thegeneralfinancialconditions(credit worthinessofborrowers,orbanks'solvency)canaffectmacroeconomicperformance. 6.3.1FinancialCollapseDuetoAdverseSelection Mankiw(1986)considersacreditmarketwithadverseselection,inthespiritofStiglitzandWeiss(1981).Thereisacontinuumpopulationofriskneutralborrowers, parameterizedbythecharacteristics(X,p)oftheirinvestmentproject.Eachprojectcostsoneunitofmoneyitsreturnis withprobabilityp(success)andzerowith probability(1p)(failure).Xisthustheexpectedreturnontheproject.Riskneutralbanksofferstandarddebtcontracts(withlimitedliability)repaymentisthusRin caseofsuccessandzeroincaseoffailure.Since(X,p)isprivateinformationoftheborrower,Rcannotbeconditionedonit.Asaconsequence,bankersare confrontedwithadverse

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Figure6.3 EquilibriaoftheCreditMarket.Thedashedlinescorrespondtothebank'sisoprofit curvesfordifferentvaluesofthemoneymarketrater.Thesolidline representstheprobabilityofrepaymentasafunctionofthenominalinterestfactorR.

selection:thefirmsthatapplyforcreditarethemoreriskyones.Indeed,afirmofcharacteristics(X,p)willapplyforcreditifandonlyifitsexpectedgainXpR exceedsitsreservationutilityU0,whichcanbeinterpretedaswhatitcangainonotheractivities(tosimplifynotations,assumeU0=0).Theaverageprobabilityof repaymentp (R)inthepopulationofborrowersisadecreasingfunctionofR:

Noticeinparticularthatp (0)=E[p]andthat conditiononthecreditmarketis

.Ifrdenotesthemoneymarketorinterbankrate(assumedtobeexogenous),theequilibrium

AsFigure6.3shows,thereisapossibilityof0,1,or2equilibria(orevenmoreifthefunction
10

isbabybehaved).

Forr=r1,therearetwoequilibria:Aisstable,andBisunstable. Forr=r2,thereisnoequilibrium(infact,anotradeequilibrium).Theequationr=rCcorresponds toacriticalsituation:auniqueequilibriumC,whichvanishesassoonasthereisasmallincreaseinr.Mankiwinterpretsthisasthepossibilityofafinancialcollapse (notice,though,thatsuchafinancialcollapsemaybesecondbestefficient).

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Aconcludingremarkonthismodelmaybeofinterest,evenifunrelatedtothemacroeconomicperspectiveadoptedhere.Mankiwalsoshowsthatevenwhenthe creditmarkethasastableequilibrium(asinA),itdoesnotcorrespondtoawelfaremaximum.Indeed,letW(R)representthesocialwelfareasafunctionoftheinterest rateoncredit.Sinceallagentsareriskneutral,W(R)issimplyequaltothesumofexcessexpectedreturnsX(1+r)oftheprojectsthatarefinanced :

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Therefore,asmalldecreaseinRenhanceswelfareifandonlyif,forthepopulationofmarginalborrowers(thatis,thelessrisky,withX=pR),theaverageofexcess returns[X(1+r)](whichisalsoequalonthatpopulationtopR(1+r))ispositive.ThisisthecaseattheequilibriumrateR*,sinceitisdefinedbythefactthatthe averageofexcessreturnspR(1+r)onallborrowers iszero.Asaconsequence,thereisscopeforpublicintervention,forexamplecreditsubsidiesorloan guaranteesprovidedbythegovernment. 6.3.2FinancialFragilityandEconomicPerformance TheModelofBernankeandGertler(1990) ElaboratingonBoydandPrescott(1986)(seechapter2),BernankeandGertler(1990)studyatwoperiod(t=1,2)generalequilibriummodel,withaninfinite numberofagents,whocanbeentrepreneurs(inproportionm)orhouseholds(inproportion1m).BernankeandGertlerconsidertwoversionsofthemodel,onein whichthetypeofagentsispubliclyobservableandoneinwhichitisnot.Thesecondversionwillbestudiedhere.Allagentsareriskneutralandhaveaccesstoa riskless(storage)technology:1unitofthe(unique)goodatt=1becomes(1+r)unitsatt=2.Theaverageinitialendowmentisnormalizedto1,butthatof entrepreneurs(we)islessthanone.Sinceinvestmentrequires1unitofthegood,theywillhavetoborrowfromhouseholds. Eachentrepreneurownsariskytechnology:1unitofthegoodatt=1becomesXunits(att=2)withprobabilityp,and0withprobability(1p).Theinitialwealthw ofeachentrepreneur(withE(w)=we)ispubliclyobservable,butpisunknownapriori:itisonlyprivatelyobservablebytheentrepreneurafteran ''evaluation''(screening)thatcostshimaneffortwhosemonetaryequivalentisC.Afterthescreeninghasbeenmade,theentrepreneurdecidestoundertaketheproject (i.e.,invest1)ifpislargeenough. TheFirstBestAllocation Obviously,theprojectsthatarefundedinthefirstbestallocationdonotdependonthedistributionofinitialendowments.Assumethefollowingnotations:

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h(p)denotesthedensityfunctionofpon[0,1]andH(p)itscumulativedistribution.
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).

Amongtheprojectsthatarescreened,onlythosewithapositiveexpectedexcessreturnwillbeundertaken(pX>1+r).Thisgivesthecutoffprobabilityp*under whichprojectsarenotfinanced:

Nowscreeningaproject(whichcoststheentrepreneurC)givesanoptiononfutureinvestment.Tocomputethevalueofthisoptionrequiresdeterminingtheexpected profitthefirmobtainsifitchoosesnottoscreen.Thevalueismax(E(p)X,1+r),butthisdiscussionwillassumethatE(p)X<1+r,sothat,absentscreening,thefirms wouldusethestoragetechnology. Nowconsiderinsteadthecaseinwhichthefirmscreens.Thefirm'sprofitwillbeEp[maxpX,(1+r)].Consequently,thevalueofscreeningistheincrementofprofitV =E[max(pX1,r,0)]thataccruestothefirmchoosingtoscreen.Thereforescreeningwilltakeplace(forallprojects)ifandonlyif

whichwillbeassumedtoholdtrue.Asaconsequence,allprojectswillbescreened.Thereforetheaggregateeconomicvariables(percapita)aregivenby

Theinvestmentoffirmsisfinancedinpartontheirownwealth,mwe(lH(p*),andinpartbyhouseholds'savingsS*,whichequalthefirms'demandforfunds:

Therestofinitialendowmentsisstored:mweH(p*)byfirmsand{1m(1H(p*))}byhouseholds.Thisfirstbestallocationwillbeimplementedifallentrepreneurshave asufficientendowment, . IntroducingCreditConstraintsandLimitedLiability Nowassumethat(atleastsomefractionof)entrepreneurscannotserffinancetheirprojects(w<1).Theyhavetofindalender(ahousehold)tofundtheremaining part(1w)11andsignwiththelenderacontractspecifyingtherepaymentRincaseofsuccess.Thelenderknowsthat,becauseoflimitedliability,therewillbeno repaymentincaseoffailure.Itisassumedthat

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Figure6.4 TimingintheBernankeGertler(1990)Model

thecontractissignedafterscreeningtakesplace,thatis,aftertheborrowerobservesp,butthatborrowerscannotcrediblycommunicatethevalueofp. ThetimingisthereforeasinFigure6.4. Inthissetup,aloancontractiscompletelydescriedbytheamount(1w)tobelentandtheamountR(whichwilldependonw)toberepaidincaseofsuccess.The characteristicsofthecontractdeterminetheminimumcutoffprobability requiredbyentrepreneurtoimplementtheproject.Itisgivenby

Theequilibriumcontractwillbedeterminedby6.26andthezeroprofit.conditionforlenders:12

Theoptionvalueofthescreeningtechnologybecomes

Using6.27,R(w)canbeeliminated,andV(w)appearstobeequaltotheexactedsurplusforpabovethecutoffpoint

Result6.3 Theconsequences'ofmoralhazardandlimitedliabilityareasfollows: 1.Thereisoverinvestment(amongprojectsthathavebeenscreened):

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2.ThereisacriticalvaluewCoffirms'wealthunderwhichprojectsarenotscreened.wCisdefinedimplicitlybyV(wC)=C. Finnswithw<wCwillprefertoinvestin thestoragetechnology.

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13

3.Thenominalinterestrate Proof

isadecreasingfunctionofw.

Whenw=1,equation6.27impliesR(1)=0,and6.26immediatelygivesthat Item1comesfromthefactthat Item2comesfromthefactthat .

isanondecreasingfunctionofw,apropertythatwillbeprovedhereafter.Indeed,

andV(1)=V>C,byassumption. Nowforafirmwithendowmentwsuchthatw<wC,theprojectwillnotbescreened,andtheexpectedreturnfromimplementingtheprojectwillbeE(p)X,inferiorto 1+r.LendingtothefirmagainstapromisedrepaymentR(w)maybeprofitableonlyif .Butinthiscasethefirmwillobtainareturnfromtheproject inferiorto1+r. Item3comesfromequation6.27,rememberingthat isincreasing:

Toestablishthat

isindeedincreasing,applytheimplicitfunctiontheoremtothesystem6.26and6.27:

Multiplyingthefirstequationby ,andaddingthem,yields

Therefore

andtheproofiscomplete.

Toobtainabetterunderstandingofwhatisunderlyingresult6.3,considerthebenchmarkcaseinwhichthereisperfectinformationonp,sothattherepayment,R(w, p),ismadecontingentalsoonthisvariable.Itiseasytoshow

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that,asexpected,thecutoffprobabilityisthenp .Therefore,itistheadverseselectiononpthatiscausingoverinvestmentandinefficiency.Thereasonthishappensis thatahigherpimplieslowerrepayments,sothatR(w,1)<R(w,p)<R(w,p*)forp>p*.IfthesedifferentpaymentsarereplacedbytheiraverageR(w),thisresultsin taxinghighprobabilityfirmsandsubsidizinglowprobabilityones.Asaconsequenceofthissubsidy(duetoadverseselection),lowprobabilityfirmswillbewillingto implementtheprojectevenforlow(inefficient)valuesofp,thatis,intherange( ,p*). MacroeconomicImplications Thissubsectionwilldiscussthemacroeconomicconsequencesofresult6.3bycomputingthegeneralequilibriumofthiseconomy.LetF(w)denotethedistribution functionofthefirms'wealth,withassociateddensityf(w)andsupport[w0,w1].Theinterestingcaseiswhen

thatis,whenthefirmswithwbetweenw0andwCareactuallycreditconstrained. Theexpectedoutput(netofscreeningcosts)ofafirmofwealthwis

Theaggregateeconomicvariables(percapita)are

(rememberthatmdenotestheproportionofentrepreneurs),tobecomparedwiththeirfirstbestlevels:

Therefore,itappearsthattheglobalperformance(outputqandinvestmentI)ofthiseconomydoesnotdependonlyonthe"fundamentals"ofinvestment(i.e.,p*,m,V, andC)butalsoonthefinancialsituationoffirms(capturedhere

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bythedistributionoftheirinitialwealthw).Inparticular,whenmanyentrepreneurshavelowwealth(i.e.,whenF(wC)isclosetoone,orwCclosetow1investmentand outputwillbelowevenifthefundamentalsaregood.ThissituationisdescribedbyBernankeandGertleras"financialfragility."Moreover,ifthereisashockonthe distributionofwsuchthatw1fallsbelowwC,acollapseofinvestmentwilloccurasaresultofthepoorfinancialconditionoffirms. BernankeandGertlerproceedtodiscussthepolicyimplicationsoftheirresults.Forinstance,ifthetypesofagentsarenotobservable(thecasediscussedhere),they showthatataxonsuccessfulinvestmentprojects(usedtosubsidizehouseholds)willbewelfareimproving.Thisisbecauseentrepreneurstendtoinvestintoomany projects( )therefore,byreducingtheprofitabilityofinvestments,ataxmakesentrepreneursmoreselective.However,thispositiveeffectiscounterbalanced byareductionofthescreeningactivity(becausethevalueoftheoptionisreducedbythetax).Inthecaseinwhichtypesareobservable,amoreinterestingwelfare improvingpolicyconsistsinsubsidizingentrepreneursbytaxinghouseholds.Thiscouldbeinterpretedasbailingoutdebtors(asintheleastdevelopedcountries[LDC] debtcrisis)oraslendingmoneyto"illiquid"entrepreneurs.BernankeandGertlerextendtheinterpretationoftheirresultstojustifythelenderoflastresortpolicyofthe CentralBank,aimedatprotectingfinancialinstitutionsfromliquidityshocks. 6.4FinancialCyclesandFluctuations Thissectionwillexplorethepossibleexplanationofbusinesscyclesandeconomicfluctuationsthatcanbeattributedtofinancialconstraintsorimperfections. Fluctuationsofmacroeconomicvariables(output,investment,employment)arenotsurprisingperse,assoonasthe"fundamentals"oftheeconomy(i.e.,productivity anddemandparameters)randomlyfluctuateacrosstime.However,traditionaltheoriesfinditdifficulttoexplaintwoqualitativepropertiesofempiricaldata: macroeconomicvariablesseemtofluctuatemuchmorethanthefundamentals,andtheytypicallyexhibitautocorrelationandcyclicalbehavior,whichseemstoindicate thattransitoryshocksmayhavepersistenteffects.Understandingthesephenomenaisimportantnotonlyasatheoreticalquestion,butalsoinprovidingpossible recommendationsforeconomicpolicy.Inparticulartheseissuesarecrucialtoexplainifandhowmonetaryandfiscalpoliciescanhaverealeffectsbothintheshortrun (stabilization)andinthelongrun(growth).Twopossibleexplanationsoffinancialcycleswillbegiveninthepresentsection:thefirstreliesonbankruptcyconstraints (Farmer1984),andthesecondfocusesontheroleofrealassetsascollateral(KiyotakiandMoore1995).14

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6.4.1BankruptcyConstraints Farmer(1984)offersanewtheoryofthebusinesscyclethatcombinestwoingredients:imperfectionofcreditmarketsduetoasymmetricinformationandnonexistence ofacompletesystemoffuturesmarketsduetooverlappinggenerations. TheModel Themodelisaninfinitehorizonoverlappinggenerationsmodel,withanalternationofproductionperiods .Eachagentlivesfor2productionperiods and3marketperiods:agentsofgenerationtarebornatMt1anddieatMt+1.Therearetwogoods,laborandaconsumptiongoodthatcanalsobeusedascapitaland storeduntilthenextperiod.Productiontakesplaceondistinct"islands"(withoneworkerperislandandnomobilityoflaborbutperfectmobilityofcapital)witha Leontieftechnology.Ifaworkeronagivenislandreceivescapitalk tatperiodPt,hisorhernetproductionis

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where denoteslaborsupply,d >0capturesthedepreciationofcapital,andst(productivityshockknownonlybytheworker)representstherealizationofa randomvariablewithdensityh(s)onasupportnormalizedto[0,1].Theserealizationsareidenticallyindependentlydistributedacrossworkers(islands). AtperiodMt1,thenewlybornagents(generationt)signlaborcontractswithcapitalists(generationt1),whichspecifylaborsupplyforperiodPtandthesharingof outputatperiodMt.Workersconsume whereuisconcaveincreasing. OptimalContracts Inaperfectworldwithoutasymmetricinformation,eachproductionunitwouldreceiveoneunitofcapital,workerswouldbeactiveexactlywhen ,andthey wouldbeperfectlyinsuredbycapitalists.Inotherwords,theywouldreceivewwheninactiveandwouldrepay1+stwwhenactive.Intheimperfectworldinwhich stistheprivateobservationoftheworker,thepromisedrepaymentcandependonlyonwhetherheisactiveornot(incentivecompatibilityconstraint).Moreover, limitedliabilityimpliesthatnorepaymentisfeasiblewhentheworkerisinactive(bankruptcyconstraint).Thereforetheoptimalcontractrepaymentcanonlytaketwo values:theworkerrepaysR

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Figure6.5 ReturnonCapitalasaFunctionoftheNominalInterestFactor

(nominalinterestfactor)whenheisactiveandnothingwhenheisnot.Asusual,thenominalinterestrateinfluencestheprobabilityofrepayment:

Tofixideas,assumethatworkershaveallthebargainingpower,sothatthenominalinterestfactorwillbetheminimumratesuchthatthelenders'expectedreturn exceedsthegrossreturnrongovernmentbonds:

Thus,tosomeextentthesituationisthesameasinMankiw(1986),inwhichthenominalinterestrateR( )canbedefinedasabovefor MacroeconomicEquilibrium

(seeFigure6.5).

Bythelawoflargenumbers,theavengeproductivityoflaboroverallislandsisconstant:itisequalto( .Firstbestoptimalitywouldrequirethatallworkerswith productivitiesaboved 1beactive.Moreover,becauseoftheLeontieftechnologyandbecausecapitalhastobeinvestedbeforestisknown,thereisnoflexibilityon capitalallocation:eachislandshouldreceiveoneunitofcapital.Thefirstbestproductionlevelistherefore

whereKisthetotalstockofcapital.

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Withoutthebankruptcyconstraint,thiscouldbeimplementedbyrequiringworkerstorepayrregardlessofwhethertheyareactiveornot.Becauseofthis bankruptcyconstraint,therepaymentRisexigibleonlyiftheworkerisactive,whichdistortstheparticipationdecision.Indeed,theeffectiveproductionlevelisa decreasingfunctionofthenominalinterestfactorR:

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whereRisitselfafunctionofr,definedbyrelation6.30. Finally,risdeterminedbytheequilibriumontheassetmarket.AtperiodMt,theassetdemanda(Wt)ofanindividualmemberofgenerationtisdeterminedby

where

denotesthe(random)wealthofthisindividual.Tofixideas,considerthefollowingspecification:

forwhichtheindividualassetdemandiseasilyfound:

Thentheaggregateassetdemandatdatetis

whichisdenotedby

whereA1isincreasingandA2isdecreasing(noticethatRisincreasinginrandYisdecreasinginR).Theassetmarketequilibrium(whichdeterminesbyWalras'slaw theequilibriumofthewholeeconomy)willthenbedefinedasasequence ofinterestfactorssuchthat,forallt,

whereKtrepresentsthestockofprivatecapitalandBtisthestockofgovernmentdebt.BecauseoftheLeontieftechnology,thedemandforcapitalis

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inelastic:

),thedynamicpathofequilibriuminterestratesisgivenby

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Noticethat,absentthebankruptcyconstraint,theaggregateassetdemand wouldbeA1(rt+1)Y*andtheequilibriuminterestratewouldbeconstant:

Moreover,theborrowingpolicyofthegovernment(whichdeterminesBt)wouldaffectonlythe(nominal)interestratert+1andnottheoutputY*.Becauseofthe bankruptcyconstraint,thingsareverydifferenthere.Apositiveshockoninterestratesatdatetcanhaveapersistenteffect,eventhoughboththeproductivityof capitalandthesupplyoffinancialassets(Kt+Bt)remainconstant.Thisiseasytodeducefromequation6.35(or6.36):ifrtincreases,theeffectiveproductionlevelY [R(rt)]decreases,whichnegativelyaffectsthewealthofgenerationt.Asaconsequence,therateofreturndemandedbythisgenerationforbuyingthe(constant)stock ofassetsincreases.Itisalsointerestingtonoticethattheborrowingpolicyofthegovernment(representedherebyB)hasalongtermimpactontheaggregate productionlevel,sincethelatterdependsonthesteadystateinterestfactorr*determinedbytheequation

Tosummarize,theessenceofFarmer's(1984)contributionistopointoutthecomplexrealeffectsoffinancialcontracting.Onceasymmetricinformationandlimited liabilityareintroduced,Farmershowsthattoday'sproductivityshockswillaffecttomorrow'sinterestrates.Asaconsequence,realaggregatevariablesdependnot onlyoncurrentshocksbutalsoonallthehistoryofthepastones. 6.4.2CreditCycles KiyotakiandMoore(1995)consideraneconomyinwhichcreditcyclesappearbecauseoftwoingredients:somefirmsarecreditconstrainedandtheyusetheir productiveassetsascollateral.Theauthorsshowhow,borrowingpossibilitiesbeinglimitedbycollateral,smallproductivityshockscantriggercreditcycles.Ina perfectcapitalmarket,anegativeshockonthereturnoftheproductiveassetwouldonlymakethevalueofthisassetdecreaseuntilanewequilibriumisreached.But whenloansarecollateralized(andfirmsarecreditconstrained),theamountborrowedisdeterminedbythevalueofcollateralthereforethedecreaseinthepriceofthe productiveassetwillalsohaveanegativeimpacton

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thefirms'investment.Thiseffectiscumulative:adecreaseinthefirms'investmentdecreasesfuturerevenuesoffirms,theirnetworthfalls,andinvestmentisdecreased furtheruntilthepriceoftheassetissolowthatitstartsbeingsoldtofirmsthatarenotcreditconstrained,orusedforotherpurposes.
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ThisdiscussionwilluseasimplifiedversionofthemodelofKiyotakiandMoore,inspiredbyTirole(1994).Theeconomyiscomposedof(alargenumberof)risk neutralinfinitelylivedagentswhoseektomaximizethediscountedsumoftheirexpectedconsumptions(i.e., ).Thereareonlytwogoods:anonstorable physicalgoodusedforconsumptionandproduction,andacapitalgood(realestate)usedascollateralbyborrowersandalsoasaproductiveasset.Therearetwo classesofagents:entrepreneurswhoownthetechnologyandtheproductiveasset(say,theland),andlenderswhoreceiveendowmentsoftheconsumptiongood. Thereforeentrepreneurshavetoborrowalltheconsumptiongoodtheyinvestintheirprojects.ThetechnologyisoftheLeontieftypewithconstantreturnstoscale: withoneunitoftheconsumptiongoodandlunitsoflandinvestedatdatet,eachentrepreneurobtainsXunitsoftheconsumptiongoodatdatet+1. Theuseofcollateralcanbejustifiedinmanyways.Still,thesimplestoneistoUseHartandMoore's(1994)ideaofinalienabilityofhumancapitaldiscussedin Chapter4.Inaoneperiodcontract,eveniftheloanisrisklessitmustbefullycollateralizedtopreventrenegotiationofthetermsofthecontract. Assumingthattheloanmustbefullycollateralizedmeansinthepresentcontextthattheamountoffuturedebtcannotexceedthefuturevalueofland.Ifk tistheamount oflandtheborrowerownsduringperiodtandqt+1isthefuturepriceofland(whichisperfectlyforecastedbylenders),theamountoftheloanbtmustbesuchthatthe borrower'stotalliabilityatdatet+1(bt(l+r),where istherisklessrate)islessthanthefuturevalueofcollateralk tqt+1:

Assumethisconstraintholdswithequality,whichcorrespondstoFisher'sideaofcreditconstrainedinvestment. Assumealsothatthereisanalternativeuseforlandthelandcanbelenttoanothercategoryofagentsforotherpurposessuchasresidentialrealestate.The(inverse) demandforresidentialrealestatedeterminestherentalpricehtasafunctionofthetotalsupplyofresidentialrealestate.Sincethetotalstockofrealestateisfixed,the rentalratehtisanincreasingfunctionofthequantityAtofrealestateusedforproduction.Forsimplicity,takealinearspecificationforthisinversedemandfunction:

ItremainstodetermineAtandtheequilibriumpriceoftheasset,qt.

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LetAdenotethetotalstockoflandavailable,whichisassumedtobeheldbyentrepreneurs.Sinceinvestmentiscreditconstrained,thequantityAtoflandthatisused fortheproductiveactivityissimply timesthetotalamountthatfirmsareabletoborrow(i.e.,

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).Consequently,

Noticethereforethattheaggregateborrowingcapacityisdeterminedbythefuturepriceoflandqt+1.Thelastingredienttointroducebeforesolvingfortheequilibrium dynamicsisthenoarbitragecondition:thenetreturnonlandmustequaltherisklessrater.Thisdeterminestherelationbetweenqtandqt+1.Indeed,bybuyingoneunit oflandatdatetanentrepreneurisabletoborrowaquantityqt+l/(1+r)oftheconsumptiongood.Investingthisintheproductionprocess,sheobtainsaunitreturnof X(1+r),providedshededicatesafraction ofthelandforproduction.Therestoftheland yields isusedforrental.Consequentlythenoarbitragecondition

Replacinghtbyitsvalueandrearrangingtermsyields

with

Forastablecycleoforder2toobtain,twovalues

mustbefoundsuchthat .

Itiseasytoseethatthedynamicalsystemdefinedby6.40hasastablecycleoforder2underthefollowingconditions(seeFigure6.6):

Theeconomicmechanismthatgeneratesthecyclicalbehavior(andthestablecycleABAB)intheneighborhoodofthesteadystateElcorrespondstothedebt deflationtheorydescribedbyFisherinhisearlycontribution.Indeed,startingfromEl,assumethereisanegativeshockontherealestateequilibriumpricethatwas initiallyq*andbecomesq0<q*.Apriorithishastwoimpactsonthepricef (q)atwhichtheassetwillberesoldduringthenextperiod(thispriceisgivenbytheno arbitragecondition):ontheonehand,lessprofitwill

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Figure6.6 AStableCreditCycle.(A,B)isastablecycleE1andE2aresteady states(E2isunstable).

bemadeontheproductiveactivity(sincethevalueofassetssusceptibletobeusedascollateraldecreases,thefinancialconstraintbecomesmorestringent),butonthe otherhand,moreprofitwillbemadeontherentalactivity.ItturnsoutthatinaneighborhoodofEl,f 1isdecreasing,so}hefirsteffectdominates.Moreover,onthe leftofq*,f l(q)>q,sothenegativeshockonq*willentailanincreaseintherealestatepriceatthenextdate: thefactthatattherightofq*,f l(q)<q,so .Thecyclicalbehaviorcomesfrom

Inotherwords,oncetherealestatepricehasincreasedto (thatis,abovetheequilibriumpriceq*),thesecondeffectdominates,andqisagainpulleddownbelow q*.Thecrucialelementforthisresultisthefactthatwhenfirmsarecreditconstrained,thedemandfortheproductiveassetisanincreasingfunctionofitsprice. 6.5TheRealEffectsofFinancialIntermediation BrieflyrecallthefeaturesoftheHolmstrmTirole(1994)modelstudiedinChapter2.Inthesimplestversionofthismodel,firmshavetofindexternalfinancefortheir investment(offixedsizeI),butthereisamoralhazardproblem:

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firms'managersmaychooseabadproject(withalowprobabilityofsuccesspL)insteadofagoodproject(withahighprobabilityofsuccesspH)becausethebad projectgivesthemaprivatebenefitB.However,ifthefirmismonitoredbyabank,andthemonitoringcostsC,thisprivatebenefitisdecreasedtob,withb+C<B. ThemoralhazardproblemcanbesolvedwithoutmonitoringiffirmshaveenoughcashassetsAthattheycaninvestintheirprojects.Thishappenswhencondition2.33 ofChapter2(recalledforconvenience)issatisfied:

HereRdenotestherepaymentontheloanincaseofsuccessandristhereturn(l+interestrate)thatinvestorscanobtainonthefinancialmarkets.Ifthefirm'sassets arenotworthenough,sothat6.41isnotsatisfied,themoralhazardproblemmaybesolvedbybanklending:abanklendsImtothefirm,whichisfinancedpartlybyits ownfundsandpartlybyborrowingIImAonthefinancialmarkets.Thishappenswhen

whereb denotesthegrossreturn(oneplusnetreturn)onbankloans,andrecalling2.36,

with

Finally,b isdeterminedbytheequilibriumequationofthemarketforbankingcapital:

HereGisthedistributionfunctionofthefirms'assetsA,andIm(b )equalstheportionofeachloanthatisfinancedbythebank'sownwealth,whilerisdeterminedby theequilibriumconditiononthefinancialmarket:thesavingssupplyS(r)equalsthedemandforfundsD(b ,r,C),definedby

Figure6.7representsthesegmentationoffirmsintothreecategories:thosethatcannotfindexternalfinance,thosethatobtainbankloans,andthosethatarefunded directlyinthefinancialmarkets.

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Figure6.7 RepartitionbetweentheTwoTypesofFinanceamongFirms

HolmstrmandTiroleconsiderthreetypesoffinancialshocks:acreditcrunch(whichcorrespondstoadecreaseinKm,thecapitalofthebankingindustry),a collateralsqueeze(whichcorrespondstoanegativeshock.onfirms'assets),andasavingssqueeze(whichcorrespondstoadownwardshiftinthefunctionS).They showinparticularthefollowingproperties: Result6.4 Letrandb denotetheequilibriumreturnsonfinancialmarketsandonbankloans,respectively.Then: Acreditcrunchdecreasesrandincreasesb . Acollateralsqueezedecreasesrandb . Asavingssqueezeincreasesranddecreasesb . Proof Theproofiseasilydeducedfrom6.44andislefttothereader. 6.6FinancialStructureandEconomicDevelopment Theempiricalrelationshipbetweenfinancialstructureandeconomicdevelopmenthasbeenstudiedbymanyauthors,whohaveemphasizedthestrongpositive correlationbetweentheleveloffinancial''superstructure''andtherateofgrowthoftheeconomy.Infact,ifitisarguedthatfinancialintermediationcanbejustifiedon efficiencygrounds(aswasdoneinChapter2),theneconomicdevelopmentandtheleveloffinancialintermediationwillreinforceoneanother.Understandingthisis crucialtoassessthedifferentcontributionsintherecenttheoreticalliteratureonthemacroeconomiceffectsoffinancialintermediation.

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Ofcourse,thegeneralideathatgrowthisrelatedtofinancialstructureisnotanewone,sinceitgoesbackatleasttoSchumpeter(1961)andGerschenkron(1992). Nevertheless,thespecificresultsthathavebeenobtainedmorerecentlyarebasedpreciselyontheasymmetricinformationhypothesisexploredpreviously.Therefore, althoughthisisnotatopicthatwillbedevelopedhere,thereadermaybeinterestedinexploringtheworkofGreenwoodandJovanovic(1990)andBencivengaand Smith(1991),whichareclassicalreferences. Bothmodelsshowthatfinancialintermediariestendtostimulategrowth.InGreenwoodandJovanovicintermediationarisesendogenously,andasinBoydand Prescott(1986),theroleofintermediariesistoscreentheprojects.Ifthereturnissufficientlyhigh,theinvestmentisrealizedotherwisetheintermediaryinvestsonlyin safeassets.Inthisway,theexistenceoffinancialintermediariesresultsinabetterscreeningofprojects,whichfostersahigherrateofgrowth.Themodelof BencivengaandSmithismoreinlinewiththeliquidityinsurancemodelsofDiamondandDybvig(1983).Inthesemodels,financialintermediationnotonlyfacilitates theallocationofsavingstoproductiveinvestments,butalsoleadstoalowerrateofunnecessaryprojectliquidation,whichimprovesefficiencyandpromotesgrowth. SussmanandZeira(1995)extendthedelegatedmonitoringmodelofDiamond(1984)byincludinganelementofhorizontaldifferentiation,namelytransportation costs.Theyshowthatthiscanbethesourceofafeedbackeffectbetweenrealeconomicdevelopmentandfinancialdevelopment.TheytesttheirmodelonU.S. crossstateaggregatebankingdata,andshowthatthecostoffinancialintermediationisindeedlowerinstateswithhigheroutputpercapita.Foraninterestingsurvey oftherelationsbetweenfinancialintermediationandeconomicdevelopment,seeKingandLevine(1993). Notes 1.Chapter3showedthattheindustrialorganizationofthebankingsectorcouldhaveastronginfluenceonthesemechanisms. 2.Inadditiontoalreadycitedtextbooksonmoney,anexcellentrecentreferenceisSchnadt(1993). 3.ThismodelisthesameastheonedevelopedinChapter3,subsection3.1.1. 4.Investmentcouldalsodependony,withoutchangingthereasoning. 5.IfGisheldconstant,thebudgetconstraintofthegovernment(equation6.5)impliesthatanyincreaseinRisaccompaniedbyanequaldecreaseinBg. 6.ThisapproachcanbejustifiedbytheargumentsdevelopedinChapters2and4. 7.ThiscomplexeffectofmoneyoninterestratesisalsoanalyzedinadifferentsettingbyFuerst(1992). 8.ComparetheseassumptionswithA1throughA3insubsection6.2.1. 9.Theseequationswerenumbered3.10and3.11inChapter3. 10.Noticethattherearetwoequilibriabecauseoftheassumptionthatbanksarepricetakers.Ifthediscussionassumedinstead,asintheStiglitzWeissmodel,that banksarepricesetters,then

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onlyAwouldremainanequilibrium.ByquotingaratejustsmallerthantheonecorrespondingtoB,abankcouldobtainapositiveprofit. 11.Thecostofscreeningisassumedtobenonmonetary.Thatis,Cisthemonetaryequivalentofthecostofeffortneededforscreeningprojects.
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12.Noticethatwhenw<1, wasequaltop*,6.26wouldimplyp*R(w)=r(1w),whichshouldbeequaltoA(p*)R(w)accordingto6.27.SinceA(p*)>p*,this ispossibleonlywhenR(w)=1w=0,contradictingw<1. 13.When ,allprojectsarescreened.ThisdiscussionfocusesonthemoreinterestingcaseinwhichC>V(0).

14.RelatedalternativeexplanationsaregivenbyScheinkmanandWeiss(1986),Williamson(1987),andBernankeandGertler(1989). References Bencivenga,V.R.,andB.D.Smith.1991.Financialintermediationandendogenousgrowth.ReviewofEconomicStudies58(2):195209. Bernanke,B.1983.Nonmonetaryeffectsofthefinancialcrisisinpropagationofthegreatdepression.AmericanEconomicReview73(3):25776. .1986.Alternativeexplanationsofthemoneyincomecorrelation.CarnegieRochesterConferenceSeriesonPublicPolicy25(0):4999. Bernanke,B.,andA.Blinder.1987.Bankingandmacroeconomicequilibrium.InNewapproachestomonetaryeconomics,editedbyW.BarnettandK.Singleton. Cambridge:CambridgeUniversityPress. .1988.Credit,moneyandaggregatedemand.AmericanEconomicReview78(2):43539. Bernanke,B.,andM.Gertler.1987.Bankingingeneralequilibrium.InNewapproachestomonetaryeconomics,editedbyW.BarnettandK.Singleton. Cambridge:CambridgeUniversityPress. .1989.Agencycost,networthandbusinessfluctuations.AmericanEconomicReview79(1):1431. .1990.Financialfragilityandeconomicperformance.QuarterlyJournalofEconomics105(1):87114. Bernandke,B.,andH.James.1991.Thegoldstandard,deflation,andfinancialcrisisinthegreatdepression:Aninternationalcomparison.InFinancialmarketsand financialcrises:ANationalBureauofEconomicResearchProjectreport,editedbyR.Hubbard.Chicago:UniversityofChicagoPress. Boyd,J.,andE.Prescott.1986.Financialintermediarycoalitions.JournalofEconomicTheory38(2):21132. Cook,T.,andT.Rowe1986.Instrumentsofthemoneymarket,6thedition.Richmond,Va.:FederalReserveBankofRichmond. Diamond,D.1984.Financialintermediationanddelegatedmonitoring.ReviewofEconomicStudies51(3):393414. Diamond,D.,andP.Dybvig.1983.Bankruns,depositinsurance,andliquidity.JournalofPoliticalEconomy91(3):40119. Farmer,R.1984.Newtheoryofaggregatesupply.AmericanEconomicReview74(5):92030. Fisher,I.1933.Thedebtdeflationtheoryofgreatdepressions.Econometrica,no.1(October):33757. Friedman,M.,andA.Schwartz.1963.AmonetaryhistoryoftheUnitedStates,18671960.Princeton,N.J.:PrincetonUniversityPress. Fuerst,T.1992.Liquidity,loanablefunds,andrealactivity.JournalofMonetaryEconomics29(1):324.

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Gerschenkron,A.1992.Economicbackwardnessinhistoricalperspective.InThesociologyofeconomiclife,editedbyM.GranovetterandR.Swedberg.Boulder, Colo.:WestviewPress.Articlefirstpublishedin1952.
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Gertler,M.1988.Financialstructureandaggregateeconomicactivity:Anoverview.JournalofMoney,Credit,andBanking20(3):55988. Gertler,M.,andS.Gilchrist.1992.Monetarypolicy,businesscyclesandthebehaviorofsmallmanufacturingfirms.NewYorkUniversityEconomicResearch Report,92108.NewYork:NewYorkUniversity. Goldsmith,R.1969.Financialstructureanddevelopment.NewHaven:YaleUniversityPress. Gorton,G.,andG.Penacchi.1990.Financialinnovationandtheprovisionofliquidityservices.WhartonSchool,Pittsburgh,Pa.Mimeograph. Greenwood,J.,andB.Jovanovic.1990.Financialdevelopment,growthandthedistributionofincome.JournalofPoliticalEconomy98(5):10761107. Grimaud,A.1994.Intermdiationfinancire,politiquedebase,politiquedetauxetmonnaieendogne:Unmodlesynthtique.GREMAQIDEI,Universityof Toulouse.Mimeograph. Gurley,J.,andE.Shaw.1955.Financialaspectsofeconomicdevelopment.AmericanEconomicReview65:51538. .1960.Moneyinthetheoryoffinance.Washington,D.C.:BrookingsInstitution. Hart,O.,andJ.Moore.1994.Atheoryofdebtbasedontheinalienabilityofhumancapital.QuarterlyJournalofEconomics109(4):84179. Holmstrm,B.,andJ.Tirole.1994.Financialintermediation,loanablefundsandtherealsector.Workingpaper,IDEI,UniversityofToulouse. Hoshi,T.,A.Kashyap,andD.Scharfstein.1991.Corporatestructure,liquidity,andinvestment:EvidencefromJapaneseindustrialgroups.QuarterlyJournalof Economics106(1):3360. James,C.1987.Someevidenceontheuniquenessofbankloans.JournalofFinancialEconomics19(2):217326. Kashyap,A.,andJ.Stein.1993.Monetarypolicyandbanklending.Workingpaperno.4317,NationalBureauofEconomicResearch,Cambridge. Kashyap,A.,J.C.Stein,andD.W.Wilcox.1993.Monetarypolicyandcreditconditions:Evidencefromthecompositionofexternalfinance.AmericanEconomic Review83(1):7998. King,R.G.,andR.Levine.1993.Financialintermediationandeconomicdevelopment.InCapitalmarketsandfinancialintermediation,editedbyC.Mayerand X.Vives.Cambridge:CambridgeUniversityPress. King,S.1986.Monetarytransmission:Throughbankloansorbankliabilities?JournalofMoney,Credit,andBanking18(3):290303. Kiyotaki,N.,andJ.Moore.1995.Creditcycles.Discussionpaperno.205,FinancialMarketGroup,LondonSchoolofEconomics. Mankiw,G.1986.Theallocationofcreditandfinancialcollapse.QuarterlyJournalofEconomics101(3):45570. Mishkin,F.1978.Thehouseholdbalancesheetandthegreatdepression.JournalofEconomicHistory38(4):91837. Modigliani,E,andM.Miller.1958.Thecostofcapital,corporationfinanceandthetheoryofinvestment.AmericanEconomicReview68(June):26197. Rajah,R.1992.Insidersandoutsiders:Thechoicebetweenrelationshipandarm'slengthdebt.JournalofFinance47(1):13671400. Ramey,V.1992.Howimportantisthecreditchannelofmonetarytransmission.UniversityofCalifornia,SanDiego.Mimeograph. Romer,C.D.,andD.H.Romer.1990.Newevidenceonthemonetarytransmissionmechanism.InBrookingspapersoneconomicactivity,Vol.1,14998. Roosa,R.V.1951.Interestratesandthecentralbank.InMoney,tradeandeconomicgrowth:EssaysinhonorofJohnH.Williams.NewYork:MacMillan.

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Scheinkman,J.,andL.Weiss.1986.Borrowingconstraintsandaggregateeconomicactivity.Econometrica54(1):2345. Schnadt,N.1993.ThedomesticmoneymarketsoftheUK,France,GermanyandtheUS.FMG,LondonSchoolofEconomics.Duplicated.
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Schreft,S.L.1990.Creditcontrols:1980.EconomicReview(FederalReserveBankofRichmond)76(6):2555. Schumpeter,J.1961.Thetheoryofeconomicdevelopment,translatedbyR.Opie.1934.Reprint,NewYork:OxfordUniversityPress. Sharpe,S.1990.Asymmetricinformation,banklendingandimplicitcontracts:Astylizedmodelofcustomerrelationships.JournalofFinance45(4):106987. Slovin,M.,M.Sushka,andJ.Polonchek.1993.Thevalueofbankdurability:Borrowersasbankstakeholders.JournalofFinance48(1):24766. Stiglitz,J.,andL.Weiss.1981.Creditrationinginmarketswithimperfectinformation.AmericanEconomicReview71(June):393410. Sussman,O.,andJ.Zeira.1995.Bankinganddevelopment.Discussionpaperno.1127,CentreforEconomicPolicyResearch,London. Tirole,J.1994.Lecturenotes.IDEI,Toulouse. Williamson,S.D.1987.Financialintermediation,businessfailures,andrealbusinesscycles.JournalofPoliticalEconomy95(6):1196216.

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