Temi di Discussione. EAGLE-FLI. A macroeconomic model of banking and financial interdependence in the euro area. (Working Papers) April 2016

Transcription

1 Temi di Discussione (Working Papers) EAGLE-FLI. A macroeconomic model of banking and financial inerdependence in he euro area by Nikola Bokan, Andrea Gerali, Sandra Gomes, Pascal Jacquino and Massimiliano Pisani April 216 Number 164

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3 Temi di discussione (Working papers) EAGLE-FLI. A macroeconomic model of banking and financial inerdependence in he euro area by Nikola Bokan, Andrea Gerali, Sandra Gomes, Pascal Jacquino and Massimiliano Pisani Number April 216

4 The purpose of he Temi di discussione series is o promoe he circulaion of working papers prepared wihin he Bank of Ialy or presened in Bank seminars by ouside economiss wih he aim of simulaing commens and suggesions. The views expressed in he aricles are hose of he auhors and do no involve he responsibiliy of he Bank. Ediorial Board: Piero Tommasino, Piergiorgio Alessandri, Valenina Aprigliano, Nicola Branzoli, Ines Buono, Lorenzo Burlon, Francesco Caprioli, Marco Casiraghi, Giuseppe Ilardi, Francesco Manaresi, Elisabea Olivieri, Lucia Paola Maria Rizzica, Laura Sigaloi, Massimiliano Sacchini. Ediorial Assisans: Robero Marano, Nicolea Olivani. ISSN (prin) ISSN (online) Prined by he Prining and Publishing Division of he Bank of Ialy

5 EAGLE-FLI. A MACROECONOMIC MODEL OF BANKING AND FINANCIAL INTERDEPENDENCE IN THE EURO A by Nikola Bokan*, Andrea Gerali**, Sandra Gomes***, Pascal Jacquino* and Massimiliano Pisani** Absrac We incorporae financial linkages ino EAGLE, a New Keynesian muli-counry dynamic general equilibrium model of he euro area by including financial fricions and counry-specific banking secors. In his new version, called EAGLE-FLI (Euro Area and Global Economy wih Financial Linkages), banks collec deposis from domesic household and cross-couny inerbank markes and raise capial o finance loans o domesic households and firms. In order o borrow from local (regional) banks, households use domesic real esae whereas firms use boh domesic real esae and physical capial as collaeral. These feaures, ogeher wih a full descripion of rade balance and real exchange rae dynamics and a broad array of financial shocks, allow us o assess he domesic and cross-counry macroeconomic effecs of financial shocks accuraely. Our resuls suppor he views ha (1) business cycles in he euro area can be driven no only by real shocks bu also by financial ones, (2) he financial secor could amplify he ransmission of (real) shocks and (3) financial/banking shocks and banking secors can be sources of business cycle asymmeries and spillovers across counries in a moneary union. JEL Classificaion: E51, E32, E44, F45, F47. Keywords: Banks, DSGE models, economeric models, financial fricions, open-economy macroeconomics, policy analysis. Conens 1. Inroducion The model The banking secor Households Enrepreneur Firms Moneary auhoriy Marke clearing condiions Ne foreign asse posiion and inernaional relaive prices Calibraion Simulaions Reducion in he EA moneary policy rae Increase in LTV raio Increase in banks lending in he inerbank marke Increase in he bank capial requiremen Sensiiviy analysis Conclusions References... 3 Tables and Figures Technical Appendix: Equaions * European Cenral Bank. ** Bank of Ialy. *** Bank of Porugal.

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7 1 Inroducion 1 The recen financial crisis, which has resuled in a long period of economic sagnaion and exremely low inflaion, especially in he euro area (EA), and he ensuing debae on policy responses (in paricular by cenral banks) have widely increased he need for undersanding how domesic and cross-counry financial facors migh affec macroeconomic performance in a moneary union such as he EA. Cross-counry heerogeneous condiions in financial markes and banking secors wihin he union can make i difficul for he common moneary policy o guaranee he union-wide macroeconomic sabiliy, while calling for macroprudenial policies o foser financial sabiliy a a counry and, hence, union level. Thus, undersanding he role of counry-specific srucural financial and banking feaures, heir ineracion wihin and across regions and heir effec on he ransmission mechanism of moneary policy is crucial for a proper analysis of moneary and financial sabilizaion issues in a moneary union, and in paricular for a horough assessmen of policy responses in he EA in he afermah of he recen financial crisis. To ackle hese issues we enrich a muli-counry model of he EA called EAGLE (Euro Area and GLobal Economy) model wih financial fricions, banking secors and a cross-counry inerbank marke. 2 This paper describes he new model seup, labeled EAGLE-FLI (Euro Area and GLobal Economy wih Financial LInkages), 3 and ransmission mechanism via a se of simulaions, ha shows he macroeconomic effecs of several financial shocks, o illusrae is usefulness from a policy perspecive. The original EAGLE model is a large-scale microfounded model developed for he analysis of spillovers and macroeconomic inerdependence across he differen counries belonging o he EA and beween hem and oher counries ouside he moneary union. The open economy version of he New Keynesian paradigm, so called New Open Economy Macroeconomics framework, consiues EAGLE s heoreical kernel and guaranees a nonrivial role for moneary, exchange rae, fiscal and srucural policy measures. The microfoundaions of he model ogeher wih is rich srucure allow for a quaniaive analysis in a heoreically coheren and fully consisen model seup, clearly spelling ou he policy implicaions. 4 EAGLE-FLI adds he following feaures o he original EAGLE framework. Firs, we inroduce wo ypes of households, namely borrowers and savers. Second, we include a banking 1 We hank Güner Coenen for invaluable suppor. We hank wo anonymous referees, paricipans a he Working Group on Economeric Modeling, he EAGLE Nework meeings, he 215 DYNARE Conference. The opinions expressed are hose of he auhors and do no reflec views of heir respecive insiuions. Any remaining errors are he sole responsibiliy of he auhors. 2 See Gomes, Jacquino and Pisani (21, 212) for he descripion of he sandard EAGLE model. 3 Joinly developed by saff of Bank of Porugal, Bank of Ialy, Croaian Naional Bank and European Cenral Bank, EAGLE-FLI is a projec of he EAGLE Nework, under he auspices of he Working Group on Economeric Modeling of he European Sysem of Cenral Banks. 4 The EAGLE seup builds on he New Area Wide Model (NAWM, Coenen, McAdam and Sraub, 28). See also he IMF s Global Economy Model (GEM, Laxon and Peseni, 23 and Peseni, 28), he Bank of Canada s version of GEM (Lalonde and Muir, 27), he Federal Reserve Board s SIGMA (Erceg, Guerrieri and Gus, 26), he European Commission s QUEST (Rao, Roeger and in Veld, 29), and IMF s Global Inegraed Moneary Fiscal Model (GIMF, Kumhof and Laxon, 27). 5

8 secor ha inermediaes credi flows (banking loans and deposis) in each of he four regions of he model. Third, we inroduce a real esae secor in he economy ha provides housing services o households, a sock of collaeral o borrowers and ha is used as an inpu in producion. In each region, a bank collecs deposis from domesic savers, raises capial subjec o a regulaory requiremen and lends boh o domesic borrowing households and enrepreneurs, subjec o a collaeral consrain wrien on heir real esae holdings and, for enrepreneurs, also on heir physical capial. In addiion, only banks locaed in he wo EA regions have access o an inerbank marke o exchange funds cross-counry. Fourh, we enrich he model wih a se of financial shocks, such as shocks o he loan-o-value (LTV) raio, he amoun of resources ha banks desire o lend in he inerbank marke, and he bank capial requiremen. The shocks are simulaed under perfec foresigh, so households and firms perfecly anicipae heir ineremporal pah, bu no he value in he iniial period (he surprise ). We also repor a sensiiviy analysis o furher show he relevance of some key financial parameers for he ransmission of he shocks. Our resuls aim a explaining he domesic and cross-counry ransmission mechanism of various shocks in a moneary union model where financial facors do maer. Even hough he analysis does no aim o quaniaively explain neiher he EA business cycle nor he recen financial crisis, he resuls suppor he views ha (1) he business cycles in he EA can be driven no only by real shocks, bu also by financial shocks, (2) he financial secor could amplify he ransmission of (real) shocks, and (3) he financial/banking shocks and he banking secors can be a source of business cycle asymmeries across counries in a moneary union. The EAGLE-FLI seup builds on several earlier conribuions. 5 The disincion beween borrowers, enrepreneurs and savers follows Iacoviello (25). As in ha conribuion, we assume ha enrepreneurs and a fracion of households (he borrowers ) are more impaien han remaining households (he savers ), i.e. he former have a lower discoun rae han he laer. Thus, he corresponding borrowing consrains are binding in he seady sae and in is neighborhood. The banking secor is akin o he one in Iacoviello (215). 6 Regarding he capial requiremen raio, we follow Kollmann (213) and Kollmann, Rao and Roeger (213), and impose ha in every period he bank capial should no be less han a (possibly ime-varying) fracion of he bank loans o domesic households and enrepreneurs in he same period. Kollmann (213) and Kollmann, Rao and Roeger (213) consider he case of a global bank lending domesically and abroad. Differen from hem, we do no have a global bank ha originaes cross-border loans. Insead, we have counry-specific banks ha lend o and receive deposis from domesic agens and ha, in he case of EA blocs, lend o each oher in he EA 5 In line wih hese conribuions, we assume a cashless economy, so here is no explici role for money. The moneary policy rae, se according o a Taylor rule, is linked o he oher ineres raes, including he one holding in he inerbank marke, via no-arbirage condiions obained from banks, households and enrepreneurs maximizaion problems. 6 We follow Iacoviello (215) and assume ha enrepreneurs borrow agains real esae and physical capial. This is differen from Iacoviello (25), where boh borrowers and enrepreneurs use real esae as collaeral. 6

9 inerbank marke. Allowing banks o lend and borrow a inernaional level is differen from allowing households o do he same, as hey maximize differen objecives subjec o differen consrains, such as he capial requiremen. EAGLE-FLI feaures financial spillovers ha direcly affec banks behavior, and only indirecly (via banks) he foreign borrowers while in Kollmann (213) and Kollmann, Rao and Roeger (213) here is a direc spillover from bank o foreign borrowers. The region-specific banking secor seup is also used in Brzoza-Brzezina, Kolasa, and Makarski (215), who develop a moneary union model of he EA feauring wo regional banking secors. Guerrieri, Iacoviello, and Minei (212) consider a wo-region model calibraed o he EA feauring regional banks and sovereign deb defaul. Differen from hese conribuions, we inroduce a region specific banking secor in a large-scale open-economy New Keynesian dynamic general equilibrium model. Thus, he model includes several ingrediens needed for he quaniaive assessmen of cross-counry financial and banking spillovers in a moneary union. 7 The paper is organized as follows. Secion 2 shows he seup of he banking and financial secors. Secion 3 repors he calibraion. Secion 4 conains he resuls of simulaing financial shocks and he sensiiviy analysis. Secion 5 concludes. 2 The model In his secion we repor he novel feaures ha characerize he EAGLE-FLI seup. The model feaures he world economy, whose size is normalized o one. I consiss of four blocs (each bloc represens a counry or a region). s H,s,s US > are respecively he sizes of, and US blocs, and s H +s +s US < 1. For each bloc, he size of he economy corresponds o he size of populaion (sum of households, bankers, enrepreneurs) and o he size of each firms secor (inermediae radable, inermediae nonradable, final nonradable secors). We assume ha wo blocs, labelled (H) and res of he EA (), are members of a moneary union, he EA. Thus, hey share he moneary policy auhoriy and he nominal exchange raes agains he remaining wo blocs, assumed o represen he U.S. (US) and he res of he world (RW). In wha follows we focus on a descripion of he H bloc of he EA. We describe he banking secor, households and enrepreneurs behavior, he moneary auhoriy, marke clearing condiions, ne foreign asse posiion and inernaional relaive prices. Oher blocs are similar, so we do no repor he relaed equaions o save on space. The excepion is ha he US and RW blocs differ from hose of he EA because heir banking secors do no lend/borrow in a cross-border inerbank marke. 7 Gerali e al. (21) esimae a model of he EA as a whole feauring a banking secor. Lombardo and McAdam (212) esimae a model of he EA as a whole wih financial fricions. 7

10 2.1 The banking secor The economy is populaed by a coninuum of banks ha ac under perfec compeiion and, hence, maximize profis aking ineres raes as given and choosing he opimal amoun of asses and liabiliies. The banks are a fracion < ω B < 1 of he H bloc populaion. They have he same preferences, consrains and iniial asse posiions. Thus, hey make he same opimal choices and i is possible o assume a represenaive bank (he bank ). The banking secor inermediaes funds beween agens ha canno direcly lend o and borrow from each oher (a crucial assumpion for including he banking secor in a meaningful way in he model). The bank finances loans o domesic impaien households (he borrowers ) and o domesic enrepreneurs by collecing deposis of domesic paien households (he savers ) and raising capial. Moreover, he bank akes a posiion in he (cross-counry) EA inerbank marke. Uiliy. The lifeime uiliy funcion of he represenaive bank is defined in erms of real dividends E k= ( ) 1 σ (β B ) k 1 DIV B +k 1 σ P+k C, (1) where E is he expecaion operaor, < β B < 1 is he discoun facor, 1/σ > is he ineremporal elasiciyof subsiuion, DIV B represens nominal dividends from banking inermediaion aciviy and P C is he domesic privae consumpion deflaor. The budge consrain. Deposis, loans, and he posiion in he inerbank marke are all defined as one-period euro-denominaed nominal asses or liabiliies. The bank s nominal budge consrain in period is: DIV B = L +R L 1 L 1 L IB +R IB 1 LIB 1 +D Supply R D 1D Supply 1 P C Γ L, P C Γ IB, P C Γ X,, (2) where L denoes he amoun of loans graned o domesic enrepreneurs and borrowers a he predeermined gross ineres rae R L (i is paid a he beginning of period +1 and i is known in period ); 8 L IB is he amoun of loans graned o he banking secor in EA inerbank marke a he gross ineres rae R IB ; D Supply denoes households deposis, ha pay he gross ineres rae R D. The erms Γ L,, Γ IB, and Γ X, are coss he bank faces when adjusing he amoun of loans graned, he posiion in he inerbank marke and he excess bank capial, respecively. They are specified in real erms, i.e. in consumpion unis (so hey are muliplied by he consumpion deflaor P C ). The real cos Γ L, (in erms of consumpion unis) is defined 8 The same assumpion holds for oher ineres raes. 8

11 in erms of changes in loans o allow for a gradual response o a given shock: Γ L, γ L 2 ( ) 2 l 1, l 1 where γ L > is a parameer, l = L (i.e. he amoun of loans measured in consumpion unis). P C The remaining coss will be defined below. The inerbank marke. The H bank can borrow from or lend o he bank in he EA inerbank marke, subjec o he following real adjusmen cos Γ IB, γ IB 2 ( l IB κib p Y ) 2 Y, (3) ω B where γ IB > is a parameer and l IB LIB. The adjusmen cos inroduces a wedge beween P C he ineres rae on inerbank loans and he ineres rae on deposis. p Y and Y represen he seady-sae oupu deflaor (expressed in real erms, i.e. divided by he consumpion deflaor) and real oupu, respecively. The parameer κ IB ω B l IB p Y Y (4) is he seady-sae inerbank aggregae loan-o-gdp raio (where l IB is he seady-sae amoun of inerbank loans by he represenaive H bank, measured in consumpion unis). The inerbank marke is formalized in a raher sylized way. The model represens a cashless economy (see Woodford, 1998) so we absrac from money and, hence, from inerbank liquidiy as well. However, he inroducion of his marke in he model allows us o evaluae cross-counry spillovers direcly associaed wih one regional bank s behavior owards he oher regional bank. This is relevan in he ligh of he recen EA economic hisory, characerized by relevan changes in he amoun of cross-counry inerbank lending. In paricular, inroducing he inerbank marke allows o ge a bank-specific shock by exogenously shocking is posiion on his marke via he parameer κ IB. This can be inerpreed as a change in he long-run desired amoun of inerbank lending, ha may be relaed o facors no formalized such as changes in liquidiy needs or aiude oward risk. Capial requiremen. As in Kollmann (213), he bank faces a regulaory capial requiremen, i.e., is period nominal capial K B = L D Supply +L IB (5) should no be less han a (possibly ime-varying) fracion < Υ K, < 1 of is loans o domesic 9

12 householdsandenrepreneursinhesameperiod, L. 9 Wedefinehenominalexcessbankcapial, a he end of period, as X (1 Υ K, )L D Supply +L IB. (6) We assume i is cosly, in erms of consumpion unis, for he bank o deviae from he long-run (seady-sae) value of excess bank capial, according o he following quadraic funcion: 1 Γ X, γ X 2 (x x) 2, (7) where γ X > is a parameer, x X is excess bank capial expressed in consumpion unis P C and x is is seady-sae value. This adjusmen cos inroduces a wedge beween he ineres rae on domesic loans and he ineres rae on deposis. Firs order condiions (FOC). The represenaive bank maximizes lifeime uiliy (1) subjec o is budge consrain (2) and he cos from deviaing from he capial requiremen (7) (given excess bank capial definiion 6) wih respec o dividends, deposi supply, loans supply and inerbank posiion. Variables are expressed in real erms by dividing hem by he consumpion price deflaor P C (hus div B DIV B /P C ). The implied FOC are: marginal uiliy of dividends Λ B, Λ B, = ( div B ) σ; (8) deposi supply [ ] Λ B, = β B E Λ B,+1 R D Π 1 C,+1 Λ B, γ X (x x), (9) where Π C,+1 PC +1; P C loans supply [ ] ( ) [ ( Λ B, = β B E Λ B,+1 R L l 1 l+1 Π 1 C,+1 γ L Λ B, 1 +β B γ L E Λ B,+1 1 l 1 l 1 l ) l+1 Λ B, γ X (1 Υ K )(x x); (1) 9 Bank capial requiremens can limi moral hazard in he presence of informaional fricions and deposi insurance. We do no model his issue and ake he capial requiremen as given. Moreover, for simpliciy, we assume ha inerbank loans are no subjec o he capial requiremen. 1 In he seady-sae equilibrium he capial requiremen is saisfied wih equaliy. Thus X = (1 Υ K )L D Supply +L IB = K B Υ K L. l 2 ] 1

13 inerbank loans [ ( Λ B, = β B E Λ B,+1 R IB Π 1 C,+1 ] Λ B, γ IB l IB κib p Y ) Y Λ B, γ X (x x). (11) ω B 2.2 Households The economy is populaed by a coninuum of wo ypes of households: paien ( savers ) and impaien ( borrowers ). I-ype households are paien while J-ype are impaien households. The savers are a fracion (1 ω J ω E ω B ) of he H populaion, where ω J and ω E (ω J,ω E >, ω J + ω E + ω B < 1) are he shares of impaien households and enrepreneurs in he H populaion, respecively. Wihin each ype, agens have he same preferences, consrains and iniial asse posiions. Each household offers a differeniaed labor service o domesic firms and acs as wage seer, under monopolisic compeiion. Each nominal wage is se according o a Calvo-ype mechanism (Calvo, 1983). I is assumed here is perfec wage risk-sharing across households of he same ype. Thus, i is possible o assume a represenaive paien household and a represenaive impaien household(here is also a represenaive enrepreneur, as repored in Secion 2.3). These wo ypes of households differ in erms of heir discoun facors, whereby paien households discoun facor is larger han ha of impaien households (β I > β J ). Thus, in equilibrium, impaien households are ne borrowers while paien households are ne lenders vis-à-vis he domesic bank. 11 Boh ypes of households consume and work. Savers have access o muliple financial asses while consrained households can only borrow from he domesic banking secor. Paien household ( Saver ) Uiliy. The represenaive paien household, labelled saver, ges uiliy from consumpion of he nondurable composie good, C I, (subjec o exernal habi formaion) and from housing services H I, and ges disuiliy from working N I, [ ( ( ) )] 1 σ E (β I ) k 1 κ CI,+k κc I,+k 1 +ι I lnh I,+k 1 1 σ 1 κ 1+ζ N1+ζ I,+k, (12) k= where < β I < 1 is he discoun facor, κ 1 measures he degree of exernal habi formaion in consumpion, σ > denoes he inverse of he ineremporal elasiciy of subsiuion, ι I > is a parameer for uiliy from housing services and ζ > is he inverse of he elasiciy of work effor wih respec o he real wage (Frisch elasiciy). Budge consrain. The paien household provides work o firms in he wo inermediae goods producion secors under monopolisic compeiion and ses wages W I, in a saggered 11 For discoun facor heerogeneiy, see Iacoviello (25). 11

14 way, à la Calvo (1983) wih indexaion. 12 She holds posiions in euro-denominaed domesic sovereign bonds, in inernaionally raded US dollar-denominaed bonds and euro-denominaed bonds (he las assumpion holds only for households in he wo EA blocs). She also deposis in he domesic bank. The nominal budge consrain is: D Dem +S H,US B US R D 1D Dem 1 +B I, B I, 1 R 1 +B EA I, B EA I, 1R 1 S H,US B 1 US RUS 1 = (1 τ N, τ Wh,)W I, N I, +(1 τ D, )DIV F Q H (H I, (1 δ H )H I, 1 ) (1+τ C, )P C C I, P C Γ DH, +TR T, (13) where D Dem is demand for bank deposis; B I, is he posiion in he domesic governmen bonds, raded only domesically beween paien household and he governmen and paying he EA (gross) moneary policy rae R ; BI, EA is he posiion in he euro-denominaed bond, raded beween EA paien households and paying he EA moneary policy rae R ; B US is holdings of bonds denominaed in US dollars, paying he (gross) ineres rae R US, se by he US cenral bank, and convered in euro currency by he nominal exchange rae relaive o he US, S H,US (euro per uni of US dollar). 13 For income, W I, N I, is labor income ( < τ N,, τ Wh, < 1 represen ax raes on labor and payrolls, respecively, boh possibly ime-varying); DIV F is income from ownership of domesic firms (oher han banks) and < τ D, < 1 he relaed ax rae. For expendiures, Q H is he price of housing ( < δ H < 1 is he depreciaion rae of he housing sock, as housing is formalized as a durable good), < τ C, < 1 is ax rae on (nondurable) consumpion good, and Γ DH is he cos of adjusing deposis, which is defined as where d Dem DDem P C Γ DH, γ DH 2 and ( d Dem κ D p Y ) 2 Y, (14) 1 ω J ω E ω B κ D (1 ω J ω E ω B ) p Y Y d Dem is he seady-sae deposi-o-gdp, where (1 ω J ω E ω B ) d Dem are per capia aggregae deposis and p Y Y is per capia aggregae oupu, boh compued in seady sae and expressed in consumpion unis. Finally, he erms TR and T represen (gross) lump-sum ransfers and axes respecively. They are se, ogeher wih public spending and ax raes, by he domesic fiscal auhoriy. (15) FOC. The household maximizes her lifeime uiliy subjec o he budge consrain aking all prices bu wages as given. All nominal variables in he budge consrain are expressed in 12 For deails see Gomes, Jacquino and Pisani (21, 212). 13 As sandard in he lieraure, we add an adjusmen cos o he ineres rae paid by he US bond so o make he bond posiion (and, hence, he model) saionary. 12

15 real erms by dividing hem by he consumpion price deflaor P C. Focusing on he new feaures of he model, namely housing and bank deposis, we obain he following FOC: marginal uiliy of consumpion Λ I, deposis demand ( ) σ CI, κc I, 1 Λ I, (1+τ C ) = ; (16) 1 κ [ ( Λ I, = β I E Λ I,+1 R D Π 1 C,+1 ] Λ I, γ DH d Dem κ D p Y Y 1 ω J ω E ω B ) ; (17) real esae demand (where q H Q H /PC ) Λ I, q H = ι I [ +β I E ΛI,+1 (1 δ H )q H ] +1. (18) H I, 212). The remaining FOC are sandard. They are repored in Gomes, Jacquino and Pisani (21, Impaien household ( borrower ) Uiliy. The represenaive impaien household represens a fracion ω J of he H populaion. Her discoun facor is smaller han hose of he paien household and he bank. This makes her, in equilibrium, borrower vis-à-vis he domesic bank. The impaien household lifeime uiliy funcion is: [ ( ( ) )] 1 σ E (β J ) k 1 κ CJ,+k κc J,+k 1 +ι J lnh J,+k 1 1 σ 1 κ 1+ζ N1+ζ J,+k, (19) k= where < β J < β I < 1 and consumpion is subjec o exernal habi. Budge consrain. The impaien household provides work o firms in he wo inermediae goods producion secors under monopolisic compeiion and ses wages W J, in a saggered way, à la Calvo(1983)wih indexaion. 14 She ges lump-sum ransfersfrom he domesic governmen, TR J /ω J, where TR J are aggregae nominal ransfers. The (nominal) budge consrain is: B J, R L 1B J, 1 = (1 τ N, τ WH, )W J, N J, (1+τ C, )P C C J, Q H (H J, (1 δ H )H J, 1 ) P C Γ B J, + TR J (2), ω J 14 For deails see Gomes, Jacquino and Pisani (21, 212). 13

16 where B J, < is he amoun of loans from domesic bank and R L is he ineres rae, and Γ BJ is he real adjusmen cos on changing he borrowing posiion, Γ BJ, γ B J 2 ( ) 2 bj, 1, (21) b J, 1 wih γ BJ > and b J, BJ,. P C Borrowing consrain. To borrow funds, he household needs collaeral, represened by he expeced value of her housing sock. Therefore, she faces he following borrowing consrain B J, R L ρ BJ ΠB J, 1 R L 1 +(1 ρ BJ )V J, E [ Q H +1 H J, ], (22) where < ρ BJ < 1 is a parameer capuring ineria in changing he borrowing limi as in Iacoviello (215), Π is he seady-sae inflaion (needed o properly calibrae he seady-sae deb and, a he same ime, saisfy he borrowing consrain) and < V J, < 1 is he (possibly ime-varying) LTV raio. The borrowing consrain is consisen wih sandard lending crieria used in he morgage marke, which limi he amoun len o a fracion of he value of he asse. FOC. The impaien household maximizes uiliy wih respec o consumpion of nondurables, housing and loans subjec o he budge consrain and he borrowing consrain and aking all prices, bu wages, as given. The reason is ha he impaien household supplies labor under monopolisic compeiion. Thus, she opimally ses her nominal wage aking labor demand by firms ino accoun. The borrowing consrain holds wih equaliy (see Iacoviello, 25). The household consumpion is subjec o exernal habi formaion. All nominal variables in he budge consrain and in he borrowing consrain are expressed in real erms by dividing hem by he consumpion price deflaor P C. Focusing on he new feaures of he model, we obain he following FOC: marginal uiliy of consumpion of nondurable goods Λ J, loans demand ( ) σ CJ, κc J, 1 Λ J, (1+τ C ) = ; (23) 1 κ [ ] Λ J, = β J E Λ J,+1 R L Π 1 C,+1 ( ) [ ( ) ] bj, 1 bj,+1 bj,+1 γ BJ Λ J, 1 +β J γ BJ E Λ J,+1 1 b J, 1 b J, 1 b J, b 2 J, [ ] + R L Λ JC, ρ BJ Πβ J E Λ JC,+1 R L Π 1 C,+1 ; (24) 14

17 real esae demand Λ J, q H = ι J [ +β J E ΛJ,+1 (1 δ H )q H ] [ ] +1 +(1 ρbj )Λ JC, V J, E q H H +1 Π C,+1, (25) J, where Λ JC, is he Lagrange muliplier of he borrowing consrain. The borrowing consrain affecs he opimal choices of borrowing and housing services (equaions 24 and 25, respecively). The muliplier equals he increase in lifeime uiliy ha would sem from borrowing R L euros, consuming or invesing he proceeds, and reducing consumpion by an appropriae amoun he following period. 2.3 Enrepreneur Uiliy. The represenaive enrepreneur represens a fracion ω E of he H populaion. She maximizes lifeime uiliy represened by ( ( ) ) 1 σ E (β E ) k 1 κ CE,+k κc E,+k 1, (26) 1 σ 1 κ k= where consumpion of nondurable goods is subjec o exernal habi. Budge consrain. The enrepreneur owns he physical capial sock and par of he aggregae domesic sock of real esae. Boh are rened in a compeiive marke o firms operaing in he domesic inermediae secors. Enrepreneurs can borrow funds from domesic banks. The invesmen in physical capial is subjec o adjusmen coss. The budge consrain reads as B E, R 1B L E, 1 = R H, H E, 1 +(1 τ K, ) ( R K, u Γ u, P I ) KE, 1 +τ K, δ K P I K E, Q H (H E, (1 δ H )H E, 1 ) (1+τ C, )P C C E, P I I E, P C Γ B E,, (27) where B E, < is he amoun of loans from domesic bank, R H, and R K, are he renal raes of real esae H E, and physical capial K E, o firms in he inermediae secor, respecively. The variable u sands for capial uilizaion and Γ u, sands for he corresponding adjusmen cos. The variable < τ K, < 1 is he ax rae on physical capial, se by he domesic fiscal auhoriy. The parameers < δ K,δ H < 1 are he depreciaion raes of capial and real esae, respecively. The variable I E, is he invesmen in physical capial, whose price is P I. The erm Γ BE represens he real adjusmen cos on changing he borrowing posiion, defined as Γ BE, γ B E 2 ( ) 2 be, 1, (28) b E, 1 wih γ BE > and b E, BE,. P C 15

18 Invesmen is subjec o adjusmen coss, namely K E, = (1 δ K )K E, 1 +(1 Γ I, )I E,, (29) where Γ I, is he adjusmen cos formulaed in erms of changes in invesmen: wih γ I >. Γ I, γ I 2 ( ) 2 IE, 1, (3) I E, 1 Borrowing consrain. The enrepreneur borrows funds B E, from he domesic banking secor using he owned real esae and physical capial as collaeral: R L B E, ρ BE ΠB E, 1 R 1 L +(1 ρ [ ] [ ] B E )V HE,E Q H +1 H E, +(1 ρbe )V KE,E Q K +1 K E,, (31) where < ρ BE < 1 is a parameer ha capures ineria in changing he borrowing posiion and < V HE,,V KE, < 1 are he (possibly ime-varying) enrepreneur s LTV raios associaed wih real esae and physical capial, respecively. Finally, Q K is he Tobin s Q, i.e. he price of capial, which is differen from one because of he adjusmen coss on invesmen change. FOC. The enrepreneur maximizes her uiliy wih respec o consumpion of nondurables goods, invesmen in physical capial, physical capial, and housing, subjec o he budge consrain and he borrowing consrain, and aking prices as given. All nominal variables in he budge consrain and in he borrowing consrain are expressed in real erms by dividing hem by he consumpion price deflaor P C. In paricular, p I P I /P C, r H, R H, /P C, r K, R K, /P C, q K Q K /PC. The FOC relaed o EAGLE-FLI novel feaures are: consumpion of nondurable goods ( ) σ CE, κc E, 1 Λ E, (1+τ C, ) = ; (32) 1 κ invesmen in physical capial p I = q K ( 1 ΓI, Γ I, I E,) +β E E [ Λ E,+1 Λ E, q K +1 Γ I,+1 IE,+1 2 I E, ] ; (33) 16

19 physical capial demand Λ E, q K = β E E [ ΛE,+1 (1 τ K, ) ( r K,+1 u +1 Γ u,+1 p I +1)] +τk, δ K p I + β E E [ ΛE,+1 q K +1(1 δ H ) ] +(1 ρ BE )Λ EC, V KE,E [ q K +1 Π C,+1 ] ;(34) real esae demand Λ E, q H = β E E [ ΛE,+1 r H,+1 +Λ E,+1 (1 δ H )q H +1] +(1 ρbe )Λ EC, V HE,E [ q H +1 Π C,+1 ] ; loans demand [ ] Λ E, = β E E Λ E,+1 R L Π 1 C,+1 ( ) be, 1 γ BE Λ E, 1 +β E γ BE E b E, 1 b E, 1 + Λ EC, R L +β Eρ BE ΠE [ Λ EC,+1 R L Π 1 C,+1 [ Λ E,+1 ( be,+1 b E, 1 ) be,+1 b 2 E, (35) ], (36) ] where Λ E, is he Lagrange muliplier of he enrepreneurs budge consrain and Λ EC, is he Lagrange muliplier of he enrepreneurs borrowing consrain. Like for impaien households, he equaions for consumpion and housing choice hold wih he addiion of he muliplier associaed wih he borrowing resricion. The borrowing consrain inroduces a wedge beween he price of he real esae and is renal rae. I can be considered as a ax on he demand for credi and for real esae. 2.4 Firms There are wo ypes of firms. One ype produces inermediae goods, eiher inernaionally radable or nonradable. The oher ype produces nonradable final goods for consumpion and invesmen purposes, using all inermediae goods as inpus. Final good firms Firms producing final nonradable goods are symmeric, ac under perfec compeiion and use nonradable as well as domesic and impored radable inermediae goods as inpus. The size of he secor is s H. The inermediae goods are assembled according o a consan elasiciy of subsiuion (CES) echnology. Final goods can be used boh for privae consumpion and invesmen. The seup of he final good firms mimics he one in he version of he EAGLE model wihou financial fricions and a banking secor (see Gomes, Jacquino and Pisani 21, 212). 17

20 Inermediae good firms There are firms producing radable and nonradable inermediae goods (brands) under a monopolisic compeiion regime. Each radable brand is produced by a firm h belonging o he coninuum of mass s H (h [,s H) ). Similarly, each nonradable brand is produced by a firm n, defined over he coninuum of mass s N (n [,s H) ). Since he EAGLE-FLI model inroduces a new inpu in producion compared o he original EAGLE model, we will describe he inermediae goods secor seup in more deail. Producion echnology. Each nonradable and radable inermediae good, respecively n and h, is produced using a Cobb-Douglas echnology wih hree inpus: physical capial rened from domesic enrepreneurs (K D (n) and K D (h)); domesic labor (N D (n) and N D (h), each being an aggregae of boh paien and impaien households labor services); real esae (H D (n) and H D (h)) rened from domesic enrepreneurs Y S,N = z N, ( K D ) αkn ( H D ) αhn ( N D ) 1 αkn α HN, (37) Y S,T = z T, ( K D ) αkt ( H D ) αht ( N D ) 1 αkt α HT, (38) where α KN,α KT,α HN,α HT >, α KT + α HT < 1, and α KN + α HN < 1. z N, and z T, are secor-specific produciviy shocks (hey are idenical across firms wihin each secor). 15 Taking inpu prices as given, firms in each secor minimize oal producion coss subjec o he respecive producion funcion (equaions 37 and 38). This yields sandard demand funcions for each ype of inpu (see he Technical Appendix). Finally, he labor bundle of he generic firm n in he nonradables secor is defined as N D (n) = [ (1 ωj ω E ω B 1 ω E ω B ) 1 ( η N D I, (n) η 1 ω η J + 1 ω E ω B ) 1 η N D J, (n) η 1 η ] η η 1, (39) where η > is he elasiciy of subsiuion beween he wo household-specific labor bundles, NI, D (n) and ND J, (n). This yields he following demand funcions: NI,(n) D = 1 ω J ω E ω B 1 ω E ω B ( WI, W ) η N D (n), (4) N D J,(n) = ω J 1 ω E ω B ( WJ, W ) η N D (n), (41) where W is [( 1 ωj ω E ω B W = 1 ω E ω B ) ( W 1 η I, + ω J 1 ω E ω B ) ] 1 W 1 η 1 η J,. (42) 15 In he case of he EA here is also a echnology shock z, which is common o boh secors and regions. 18

21 Similar bundles and demand funcions hold for firms in he radables secor. Price seing. Each firm sells is differeniaed oupu under monopolisic compeiion. The firm producing he radable inermediae good charges differen prices in local currency a home and in each foreign region. There is sluggish price adjusmen due o saggered price conracs à la Calvo (1983). Firm h in he inermediae radables secor discriminaes across counries, by invoicing and seing he price of is brand in he currency of he generic desinaion marke. Hence, he local currency pricing assumpion holds. For deails on he price seing equaions see Gomes, Jacquino and Pisani (21, 212). 2.5 Moneary auhoriy In he case of he EA, here exiss a single moneary auhoriy ha arges a weighed (by regional size) average of regional (, H, and ) annual consumer price inflaion and real quarerly oupu growh: ( R EA ) 4 = φ EA R +φ EA gy ) 4 ( ) [ + 1 φ EA R (R EA) 4 ( +φ EA Π Π EA,4 C, Π EA,4)] ( Y EA gr, 1 ) +ε EA R,, (43) ( R EA 1 where Π EA,4 is he long-run(yearly)inflaionarge andhe yearlyinflaion raeπ EA,4 C, is defined as wih Π EA,4 C, ( Π H,4 C, ) s H s H +s ( Π,4 C, Π H,4 C, PH C, PC, 4 H, Π,4 C, and he EA oupu growh rae Y EA gr, is defined as ) s s H +s, (44) P C, PC, 4, (45) gr, Y EA Y EA Y 1 EA sh Y H +s Y s H Y H 1 +s Y 1, (46) where Y H and Y represen per capia oal final real oupu in he H and regions, respecively. They are weighed by he corresponding regional sizes in he world economy. 2.6 Marke clearing condiions In his secion, we repor clearing condiions for he housing, loans, deposis, EA cross-counry inerbank markes. Housing marke. Households and enrepreneurs demand real esae, which is assumed 19

22 o be nonradable across counries and in fixed (per capia) aggregae supply H (1 ω J ω E ω B )H I, +ω J H J, +ω E H E, = H. (47) Enrepreneurs ren housing o firms producing inermediae radable and nonradable goods: H T +H NT = ω E H E,, (48) where H T = 1 s H s H H D (h)dh, H N = 1 s H s H H D (n)dn. (49) Loans marke. Bankers supply loans o domesic enrepreneurs and impaien households: ω B L +ω J B J, +ω E B E, =. (5) Deposis marke. Paien households demand bank deposis o domesic banks: ω B D Supply = (1 ω J ω E ω B )D Dem. (51) EA cross-counry inerbank marke. The wo EA regional banks lend each oher resources hrough he EA inerbank marke. The marke clearing is: s H ω H B LIB,H +s ωb L IB, =, (52) where L IB,H and L IB, are he posiions of and regions, respecively. 2.7 Ne foreign asse posiion and inernaional relaive prices holdings of foreign bonds per capia (ha is, he economy s ne foreign asse posiion in per capia erms), denominaed in US dollars, evolve according o L IB (1 ω J ω E ω B )B US, +ω B S H,US +(1 ω J ω E ω B ) BEA I, S H,US L IB 1 +ω B (1 ω J ω E ω B )B US, 1 R US +(1 ω J ω E ω B ) BEA I, 1 R 1 S H,US where TB H sands for rade balance per capia, defined as TB H s CO s H SH,CO CO H = 1R 1 IB S H,US + TBH S H,US, (53) P H,CO X, IM CO,H P H,CO IM, IMH,CO, (54) CO H 2

23 where S H,CO is he bilaeral nominal exchange rae of he counry relaive o counry CO (euro per uni of counry CO currency), IM CO,H is expors (P H,CO X, is he corresponding price index in foreign currency), IM H,CO index in euro erms). is impors (P H,CO IM, is he corresponding price The marke clearing condiions, joinly wih he budge consrains of he households, enrepreneurs, banking secor and he fiscal auhoriy, imply he following resource consrain in per capia erms P Y, Y = P C, C +P I, (I +Γ u, K )+P G, G + CO H CO H P H,CO IM, P H,CO IM, ( ( IM H,CO C, IM H,CO I, 1 Γ H,CO IM C Γ H,CO IM C 1 Γ H,CO IM I Γ H,CO IM I ) ) s CO s H SH,CO CO H P H,CO X, IM CO,H, (55) where G is public consumpion and P G, he corresponding price deflaor, and consumpion in per capia erms, C, is and C ω B C B, +(1 ω J ω E ω B )C I, +ω J C J, +ω E C E,, (56) C B, DIV B P C, (57) and Γ H,CO IM C I ω E I E,, (58) K ω E K E,, (59) is a (sandard) adjusmen coss on impors and Γ H,CO IM C is defined as 16 Γ H,CO IM C 1 Γ H,CO IM C ( ) ( ( )) IM C,CO Q C Γ H,CO IM C,CO IM C Q C IM C. The bilaeral erms of rade relaive o he generic counry CO are defined as he price of impors relaive o he price of expors, boh expressed in currency: TOT H,CO S H,CO P H,CO IM, P H,CO X,. (6) The bilaeral real exchange rae relaive o he generic counry CO is defined as he CPI 16 See Gomes, Jacquino and Pisani (21) for more deails. 21

24 of counry CO relaive o he CPI of counry H, boh expressed in currency: 3 Calibraion RER H,CO SH,CO P H C, P CO C,. (61) We calibrae a he quarerly frequency he model blocs o Germany ( counry, as in he sandard EAGLE),, US and RW. We se a subse of model parameers o mach he (usual) grea raios and he banking variables (as a raio o GDP). The remaining parameers are calibraed in line wih he lieraure, in paricular wih he calibraion of models such as EAGLE, GEM and NAWM. Table 1 repors banks balance shee, as a raio o annualized GDP. The daa is aken from Eurosa Annual Secor Accouns and he Federal Reserve Board Financial Accouns (and refer o nominal ousanding amouns a he end of he year divided by annual nominal GDP). Given he lack of available daa on collaeralized loans for oher purposes bu housing, we choose o mach he average share (over he period) of oal loans o households, namely o 64% for Germany; 61% for he ; 9% for he US; 76% for he RW. We assume ha he seady-sae (EA) inerbank posiion is zero. Given he mached values for loans o households, he assumed inerbank posiion, he assumed zero excess bank capial in he seady sae, he calibraion of he capial requiremen and he enrepreneurs LTV raios (see below), we allow deposis o endogenously adjus consisenly wih he bank s balance shee. This calibraion sraegy emphasizes he role of bank s loans and hus induces a broad inerpreaion of bank deposis (given he absence of oher financing sources such as bank bonds in he model). Table 2 repors he mached grea raios. Naional accouns daa for he EA regions and he US are aken from Eurosa. We se region sizes o mach he share of world GDP (IMF daa). The sources of EA and of US ne foreign asse posiion daa are Eurosa and Bureau of Economic Analysis, respecively. 17 Table 3 repors he parameers relaed o financial fricions and banking secor. The impaien households LTV raio is se o.7 in boh EA regions, in line wih he calibraion of he EA households LTV raio in Lombardo and McAdam (212) and he calibraion of Calza, Monacelli and Sracca (213) for Germany. The enrepreneurs LTV raio associaed wih housing as collaeral is also se o.7, while he LTV raio associaed wih capial is se o.3, in line wih he lieraure. Boh adjusmen coss on excess bank capial and on he EA inerbank posiion are se o.1 in all blocs. The adjusmen cos on deposis is se o.1. We se adjusmen coss o a raher low value o limi heir role for he dynamics of he model, while, a he same ime, preserving he model saionariy. As for he adjusmen coss on changes in loans, we se he corresponding parameers boh for he banks and he borrowers (impaien households and 17 Given he impor shares, ne foreign asse posiion and inernaional ineres rae, he seady-sae rade balance and real exchange rae level endogenously adjus. The RW is obained as a residual. 22

25 enrepreneurs) o 1.5. Finally, he capial requiremen parameer is se o 8% in he EA and he US, consisen wih he BASEL III minimum requiremen for oal capial. Table 4 repors populaion shares, preference and echnology parameers. The share of paien households in each region is se o 3%, he share of impaien households o.5 while he share of enrepreneurs is se o.1 (as repored in Table 3, he share of bankers is se o 1%). Preferences are assumed o be he same across household ypes and regions. We se he discoun facor of paien households o.9926 (implying a seady-sae annualized real ineres rae of abou 3%). The discoun facor of impaien households, enrepreneurs and bankers (he laer is repored in Table 3) are se o.96,.99 and.9926, respecively. 18 The habi persisence parameer, he ineremporal elasiciy of subsiuion and he Frisch elasiciy are respecively se o.7, 1 and.5. We se quarerly depreciaion rae of capial o be consisen wih a 1% annual depreciaion rae. The annual depreciaion rae for he housing sock is se a a lower value han ha for capial, o 4%. On he producion side, in he Cobb-Douglas producion funcions of radable and nonradable inermediae goods he bias owards capial is se o around.3 and he bias owards housing o.1 in boh radable and nonradable secors. As for he final goods baskes, he degree of subsiuabiliy beween domesic and impored radables is higher han ha beween radables and nonradables, consisen wih exising lieraure (elasiciies equal o 2.5 and.5, respecively). 19 The biases owards he radable bundle in he consumpion and invesmen baskes are equal respecively o.45 and.75 in each region of he EA and respecively o.35 and.75 in he US and RW. The weigh of domesic radable goods in he consumpion and invesmen radable baskes is differen across counries, o be coheren wih mulilaeral impor-o-gdp raios. Markups in he EA nonradables secor (a proxy for he services secor) and labor marke are higher han he corresponding values in he US and RW (see Table 5). In all regions he markup in he radables secor (a proxy for he manufacuring secor) has he same value and he markup in he nonradables secor is higher han ha in he labor marke. 2 Table 6 repors nominal and real rigidiies. We se Calvo price parameers in he domesic radables and nonradables secor o.92(12.5 quarers) in he EA, consisenly wih esimaes by Chrisoffel, Coenen, and Warne (28) and Smes and Wouers (23). Corresponding nominal rigidiies ouside he EA are equal o.75, implying an average frequency of adjusmen equal o 4 quarers, in line wih Faruqee, Laxon, and Muir (27). Calvo wage parameers and price 18 Following Iacoviello (215) a necessary condiion for enrepreneurs o be consrained is ha heir discoun facor is lower han he inverse of he reurn on loans. When his condiion is saisfied enrepreneurs will be consrained in a neighborhood of he seady sae. Similarly, banks are credi-consrained by heir capial requiremen (which holds as sric equaliy in a neighborhood of he seady sae) as long as heir discoun facor is lower han he reurns on deposis. 19 Noe ha he shor-run elasiciy for impored goods is lower because of adjusmen coss on impors. Numbers are consisen wih Bayoumi, Laxon, and Peseni (24). 2 The chosen values are consisen wih esimaes from Marins, Scarpea and Pila (1996), suggesing ha he degree of compeiion in he nonradables secor is lower han in he radables secor. Also, hese values are in line wih oher similar sudies, such as Bayoumi, Laxon, and Peseni (24), Faruqee, Laxon, and Muir (27) and Everaer and Schule (28). 23

26 parameers in he expor secor are equal o.75 in all he regions. The indexaion parameers on prices and wages are equal respecively o.5 and.75, so o ge sufficienly hump-shaped response of wages and price. For real rigidiies, we se adjusmen coss on invesmen changes o 6 in he EA and o 4 in he case of he US and RW; and adjusmen coss on consumpion and invesmen impors o 2 and 1, respecively. We se weighs of bilaeral impors on he bundles o mach he rade marix repored in Table Table 8 repors parameers in he moneary policy rules and fiscal rules. The ineres rae reacs o is lagged value (inerial componen of he moneary policy), annual inflaion and quarerly oupu growh. In he moneary union, moneary policy reacs o EA-wide variables. For fiscal rules, lump-sum axes sabilize public deb. Seady-sae raios of governmen deb over oupu are equal o 2.4 in all he regions (.6 in annual erms). Tax raes are se o be consisen wih empirical evidence (see Coenen, McAdam, and Sraub 28). 4 Simulaions In wha follows we repor he effecs of several shocks o show he main ransmission channels operaing in EAGLE-FLI. Specifically, we repor a reducion in he EA moneary policy rae, an increase in he LTV raio, an increase in he long-run amoun of inerbank lending by he bank, a simulaneous increase in he capial requiremen raio in boh and regions. The model is simulaed under perfec foresigh using DYNARE Reducion in he EA moneary policy rae Figures 1a-1d show he implicaions of a moneary policy shock in he EA. The shock is such ha here is an iniial decline in he (annualized) shor-erm nominal ineres rae of 25 basis poins. Figure 1a repors he response of he banking secor variables. Bank choices are dicaed by he no-arbirage condiions implicily given by heir FOC wih respec o he differen financial asses and liabiliies. The decrease in he moneary policy rae is ransmied o ineres raes on bank loans and bank deposis, ha also decrease. Lending o domesic (impaien) households and enrepreneurs increases, financed by he increase in deposis (paien households smooh consumpion, and hus increase heir savings). Also, bank capial slighly falls. The bank decreases is lending o bank hrough he inerbank marke o a raher small exen. Figure 1b repors he responses of borrowing and housing variables. In boh regions, he impaien household and he enrepreneur increase heir borrowing and heir demand for housing, which hey use as collaeral. Higher demand by he impaien household and he enrepreneur 21 The rade marix is calibraed using Eurosa and IMF rade saisics. 22 We repor in he Technical Appendix new equaions as hey appear in he code, i.e. in real erms. Oher equaions are he same as in Gomes, Jacquino and Pisani (21), see he Appendix herein for deails. 24

27 induces he increase in he housing price, which reinforces he impac of he shock by allowing higher borrowing agains he housing sock. Firms operaing in boh he radables and nonradables secors increase heir demand for rened housing as well, o increase producion. Figure 1c shows ha he impac of he shock on main macroeconomic variables (GDP, GDP componens and CPI inflaion) is, as expeced, expansionary. The consumpion increase is in line wih ha of GDP while invesmen increases by more. The higher EA aggregae demand leads o an increase in impors. Expors also increase, favored by he depreciaion of he real exchange rae. 23 The GDP increases slighly more han GDP does, as has a larger home bias han, i.e. a larger share of aggregae demand is saisfied by domesic producion. Consisen wih he lower home bias, impors increase more han impors, while expors increase more because of he larger increase in aggregae demand. As repored in Figure 1d, consumpion and labor by boh ypes of households increase. Consumpion of impaien households rises by a raher larger exen since he increase in house prices loosens he collaeral consrain (despie he smaller unexpeced rise in inflaion). Real wages of impaien and paien households also increase, driven by he higher labor demand by domesic firms. Spillovers o he US and he RW are raher small. To save on space, we do no repor hem. Overall, he banking secor ransmis he moneary policy simulus o he real side of he economy, favoring an increase in EA economic aciviy. The impac of he common moneary policy shock is raher similar across he wo EA regions. 4.2 Increase in LTV raio Figures 2a-2d show he effecs of a change in lending sandards applied by banks o heir cusomers. This is simulaed as an exogenous rise in he LTV raio of impaien households and enrepreneurs (V J and V HE in equaions 22 and 31, respecively). In he iniial period, he LTV raios in he increase by 1 percenage poin and subsequenly gradually reurn o heir seady-sae values (he persisence of he shock process is se o.9). Figure 2a shows he impac on bank relaed variables of he increase in he LTV raio. Alhough his can be hough as a change in he policy ha banks follow o exend heir loans, i is akin o a shif in he demand schedule for loans, as i is encoded in he collaeral consrain. The change allows impaien households and enrepreneurs o demand more loans a any given level of ineres raes, since he LTV raio has increased. The higher demand resuls in more loans being exended domesically a a higher ineres rae. To finance he higher amoun of loans, banks increase heir demand for deposis and inerbank borrowing ( lending in he inerbank marke increases), bidding up he respecive ineres raes, while a he same ime hey sar o increase heir capial holdings, alhough gradually as i is relaively cosly o deviae from he long-run value for bank capial. 23 In all figures, an increase in he real exchange rae represens a depreciaion. 25