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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Financial Business Cycles
Matteo Iacoviello
2014-1116  (August 2014)

Abstract:  Using Bayesian methods, I estimate a DSGE model where a recession is initiated by losses suffered by banks and exacerbated by their inability to extend credit to the real sector. The event triggering the recession has the workings of a redistribution shock: a small sector of the economy -- borrowers who use their home as collateral -- defaults on their loans. When banks hold little equity in excess of regulatory requirements, the losses require them to react immediately, either by recapitalizing or by deleveraging. By deleveraging, banks transform the initial shock into a credit crunch, and, to the extent that some firms depend on bank credit, amplify and propagate the shock to the real economy. I find that redistribution and other financial shocks that affect leveraged sectors accounts for two-thirds of output collapse during the Great Recession.

Full paper (326 KB PDF)

Banks, DSGE models, collateral constraints, housing, Bayesian estimation

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