Banks, Credit Market Frictions, and Business Cycles ⁄

TLDR: In this article, the authors proposed a fully micro-founded framework that incorporates an active banking sector into New Keynesian DSGE models with flnancial frictions, and evaluated the role and importance of banks's behavior and financial shocks in the U.S. business cycles.

Abstract: This paper proposes a fully micro-founded framework that incorporates an active banking sector into New Keynesian DSGE models with flnancial frictions. Then, it evaluates the role and importance of banks’s behavior and flnancial shocks in the U.S. business cycles. The banking sector consists of two types of heterogenous banks that ofier difierent 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 can endogenously default on fractions of their interbank borrowing and bank capital returns. Also, the model includes unconventional monetary policy shocks. Overall, an active banking sector amplifles real efiects of supply-side shocks, while it dampens efiects of demand-side and flnancial shocks on real variables. The presence of an active banking sector reduces the impacts of flnancial shocks, lowers macroeconomic volatilities, and improves social welfare. Moreover, expansionary unconventional monetary policies reduce negative impacts of flnancial crises.