Imperfect Banking Competition and Macroeconomic Volatility: A DSGE Framework

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The banking sector tends to be dominated by a few large players. With this imperfect competition, banks can charge a markup on their loan rate, which increases the cost of borrowing for firms. If this markup increases during an economic downturn, the impact of an unfavourable shock to the economy will be amplified. Therefore, it is important to understand how banks adjust their loan rate markup in response to macroeconomic shocks.

This paper reveals a new mechanism behind the time-varying loan rate markup in a dynamic stochastic general equilibrium framework. When the expected return from investing in capital increases, firms are more willing to borrow to finance their purchase. The greater willingness to borrow implies that firms are less sensitive to the loan rate. Banks with market power then respond to the price-insensitive demand for loans by charging a higher loan rate markup.

I find that banks adjust their loan rate markup differently in response to different macroeconomic shocks. After a contractionary monetary policy shock, the loan rate markup increases and thus raises macroeconomic volatility. In contrast, after a productivity shock, it is less clear how the loan rate markup is affected, because the duration of the shock is an influencing factor.