Real-financial Linkages through Loan Default and Bank Capital

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Last updated: July 2020

Many studies in macroeconomics argue that financial frictions do not amplify the impacts of real shocks. This finding is based on models without endogenous default on loans and bank capital. Using a model featuring endogenous interactions between firm default and bank capital, this paper revisits the propagation mechanisms of real and financial shocks. The model, calibrated to the US economy, shows that real shocks translate into a financial problem and cause persistent business cycle fluctuations through countercyclical firm default and interest-rate spread. Consistent with the previous studies, financial shocks lead the economy into booms and recessions, notably during the US financial crisis. Capital injections to banks through the Troubled Asset Relief Program were an effective policy response for mitigating the vicious cycle between loan default and interest-rate spread.