A Macroeconomic Model with a Financial Sector
National Bank of Belgium Working Paper No. 236
75 Pages Posted: 14 Oct 2012
Date Written: April 8, 2012
This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes - a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other and the economy by not maintaining adequate capital cushion.
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