The Credit Crunch. Macroeconomics IV. Ricardo J. Caballero. Spring 2011 MIT. R.J. Caballero (MIT) The Credit Crunch Spring / 16

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1 The Credit Crunch Macroeconomics IV Ricardo J. Caballero MIT Spring 2011 R.J. Caballero (MIT) The Credit Crunch Spring / 16

2 References 1 2 Bernanke, B. and A. Blinder, Credit, Money and Aggregate Demand, American EconomicReview, 78(2), , May Holmstrom, B. and J.Tirole, Financial Intermediation, Loanable Funds, and the Real Sector, Quarterly Journal of Economics, 112(3), , August R.J. Caballero (MIT) The Credit Crunch Spring / 16

3 Main points Banks play a central role in financial intermediation and can be both a source of systemic shocks and an amplification mechanism The credit channel is a key ingredient of the monetary policy transmission mechanism R.J. Caballero (MIT) The Credit Crunch Spring / 16

4 Holmstrom and Tirole Firms need external finance for investment I (fixed) Project has return R in good state, 0 in bad state Moral hazard: if entrepreneur shirks, gets private benefit B, but prob. of good state is only p L. If not, no private benefit, but prob. of good state p H > p L Monitor (bank): can spend cost C to reduce private benefit B to b, with b + C < B. Entrepreneur has wealth A, distribution g (A). Rate of return to private investors r, to banks r B > r. R.J. Caballero (MIT) The Credit Crunch Spring / 16

5 Firms fully financed by private investors Return to investor in good state R I is given by zero profits condition (if no shirking is optimal) (I A)(1 + r ) (I A)(1 + r ) = p H R I + (1 p H )0 R I = Return to entrepreneur in good state is R R I = R (I A)(1 + r )/p H Entrepreneur does not shirk if [ ] (I A)(1 + r ) B (p H p L ) R, p H which yields a critical (private investor financing) value of assets A(r ): p H p H A A(r ) = I 1 + r ( ) B R, p H p L R.J. Caballero (MIT) The Credit Crunch Spring / 16

6 Firms partially financed by banks If I m is the amount financed by banks and R m the return to the bank in the good state, the bank s zero profit condition is I m (1 + r B ) = p H R m. The bank has an incentive to monitor if C (p H p L )R m and R m is chosen such that this constraint binds (skin in the game) Since r B > r, the entrepreneur borrows the minimal amount from the bank, so p H C I m =. (1 + r B )(p H p L ) Return to investor in good state is again given by zero profits condition, which implies R I = (1 + r )(I A I m )/p H. R.J. Caballero (MIT) The Credit Crunch Spring / 16

7 Firms partially financed by banks Return to entrepreneur in good state is therefore C T R R m R I = R p H p L (1 + r )(I A I m ). p H The entrepreneur does not shirk if b T (p H P L ), which implies a critical value for assets: p H ( ) A(r B b + C, r ) = I I m (r B ) R. 1 + r p H p L Hence, the firm is financed by private investors and banks if: A(r B, r ) A A(r ), R.J. Caballero (MIT) The Credit Crunch Spring / 16

8 Equilibrium If K m is the supply of informed capital (owned by banks), market clearing implies [ ] B B Km = G (A(r)) G (A(r, r )) I m (r ). The supply of uninformed (private) capital must satisfy A(r ) I S(r ) = (I Im ( r B ) A)g (A)dA + A(r,r B ) A(r ) (I A)g (A)dA. R.J. Caballero (MIT) The Credit Crunch Spring / 16

9 Equilibrium g(a) No Finan. A_ Bank Finan. _ A Direct Finan. A R.J. Caballero (MIT) The Credit Crunch Spring / 16

10 Credit crunch Credit crunch (K m falls) r B rises, so A(r, r B ) rises uninformed capital becomes less scarce, hence, r and A(r ) fall. Flight to quality. Insights extend beyond banks. Informed capital/investors play a special role, which often gives them systemic importance. Very important for EMs. (Secondary result: Collateral Squeeze (g(a) shifts to the left): r and r B fall) R.J. Caballero (MIT) The Credit Crunch Spring / 16

11 Bernanke-Blinder (based on) IS-LM plus one basic modification: Bank loans are imperfect substitutes for bonds (corporate and public) Firms (aggregate of heterogeneous firms): investment I is financed by bonds B f (interest rate r B ) and loans L f (interest rate r L ) I (r B, r L ) = B f f (rb, r L ) + L (r B, r L ) B f f f f 1, L 2 << 0; B 2, L 1 0; I 1, I 2 < 0. R.J. Caballero (MIT) The Credit Crunch Spring / 16

12 Banks Banks: D b are deposits, R reserves and L b and B b the supply of loans and bonds, then: R + L b + B b = D b (= M), If α is the reserve ratio, we must have Loanable funds LF = L b + B b are R D b =. α LF = D b 1 α R = R. α From the banks optimal portfolio decision (LF allocation), we obtain (with µ 1 < 0, µ 2 > 0, ν 1 > 0, ν 2 < 0): L b = µ(r B, r L )R B b = ν(r B, r L )R R.J. Caballero (MIT) The Credit Crunch Spring / 16

13 LM and "IS" LM (standard): R = D h (y, r B ) α with Dh 1 > 0, Dh 2 < 0. IS (goods market plus credit market) I (r B, r L ) + G = S(y, r B ) (1) with S 1 > 0, S 2 > 0. L f (r B, r L ) = µ(r B, r L )R (2) R.J. Caballero (MIT) The Credit Crunch Spring / 16

14 LM and "IS" Solving (2) for r L gives r L = φ(r B, R) φ 1 > 0, φ 2 < 0. Substituting in (1) yields the modified IS-curve with I (r B, φ(r B, R)) + G = S(y, r B ) I R = I 2 φ 2 > 0. R.J. Caballero (MIT) The Credit Crunch Spring / 16

15 Credit Channel Expansionary M policy r B New effect Y R.J. Caballero (MIT) The Credit Crunch Spring / 16

16 Credit Channel If banks have more access to reserves, they increase loans. Frictionless (traditional): banks can always issue CDs (non-reservable funding), thus reserves are irrelevant. Evidence: Small vs large banks (latter are less constrained by R) Small vs large firms (former depend more on loans) Today (post-crisis): Banks have enormous amounts of reserves... other constraints are more binding. R.J. Caballero (MIT) The Credit Crunch Spring / 16

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