Financial Capital and the Macroeconomy: Policy Considerations

41 Pages Posted: 20 May 2011

See all articles by Michael T. Kiley

Michael T. Kiley

Board of Governors of the Federal Reserve System

Jae Sim

Board of Governors of the Federal Reserve System

Date Written: May 5, 2011

Abstract

We develop a macroeconomic model in which the balance sheet/liquidity condition of financial institutions plays an important role in the determination of asset prices and economic activity. The financial intermediaries in our model are required to make investment commitments before a complete resolution of idiosyncratic funding risk that can be addressed only by costly refinancing, forcing them to behave in a risk-averse manner. The model shows that the balance sheet condition of intermediaries can drive asset values away from their fundamentals, causing aggregate investment and output to respond to shocks to intermediaries. We use this model to evaluate several public policies designed to address balance sheet problems at financial institutions. With regard to short-run policies, we find that capital injections conditioned upon voluntary recapitalization can be a more effective tool than direct lending/asset purchases. With regard to long-run policies, we demonstrate that higher capital requirements can have sizable short-run effects on economic activity if not implemented carefully, and that a long transition period helps avoid such effects.

Keywords: Capital market friction, financial intermediary, capital constraint, Liquidity based asset pricing, asset purchase program, capital injection policy, regulatory capital standards

JEL Classification: E32, E44, E63

Suggested Citation

Kiley, Michael T. and Sim, Jae W., Financial Capital and the Macroeconomy: Policy Considerations (May 5, 2011). FEDS Working Paper No. 2011-28. Available at SSRN: https://ssrn.com/abstract=1845615 or http://dx.doi.org/10.2139/ssrn.1845615

Michael T. Kiley (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Washington, DC 20551
United States
202-452-2448 (Phone)
202-452-5296 (Fax)

Jae W. Sim

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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