Financial Intermediation, Leverage, and Macroeconomic Instability

American Economic Journal, Forthcoming

28 Pages Posted: 15 Sep 2016

Date Written: January 20, 2016

Abstract

This paper investigates how financial-sector leverage affects macroeconomic instability and welfare. In the model, banks borrow (use leverage) to allocate resources to productive projects and provide liquidity. When banks do not actively issue new equity, aggregate outcomes depend on the level of equity in the financial sector. Equilibrium is inefficient because agents do not internalize how their decisions affect volatility, aggregate leverage, and the returns on assets. Leverage creates systemic risk, which increases the frequency and duration of crises. Limiting leverage decreases asset-price volatility and increases expected returns, which decrease the likelihood that the financial sector is undercapitalized.

Keywords: Leverage, Macroeconomic Instability, Borrowing Constraints, Banks, Macroprudential Regulation, Financial Crises

JEL Classification: E44, G01, G20

Suggested Citation

Phelan, Gregory, Financial Intermediation, Leverage, and Macroeconomic Instability (January 20, 2016). American Economic Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2838423

Gregory Phelan (Contact Author)

Williams College ( email )

Williamstown, MA 01267
United States

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