Contagion Along the Business Cycle

82 Pages Posted: 11 Jun 2018

See all articles by Massimo Ferrari

Massimo Ferrari

Università Cattolica del Sacro Cuore (UCSC)

Date Written: May 25, 2018

Abstract

In this paper, I incorporate a complex network model into a state of the art stochastic general equilibrium framework with an active interbank market. On this market banks exchange funds one another giving rise to a complex network of interbanking relations. With the tools of network analysis it is possible to study how contagion spreads between banks and what is the probability and size of a cascade (a sequence of defaults) generated by a single initial episode. These two variables are a key component to understand systemic risk and to assess the stability of the banking system. In extreme scenarios, the system may experience a phase transition when the consequences of one single initial shock affect the entire population. I show that the size and probability of a cascade evolve along the business cycle and how they respond to exogenous shocks. Financial shocks have a larger impact on contagion probability than real shocks that, however, are long lasting. Additionally I find that monetary policy faces a trade off between financial stability and macroeconomic stabilization. In particular, responding to the contagion probability reduces risk on financial markets at the cost of higher volatility of real variables. Government spending shocks, on the contrary, have smaller effects on both. Finally I analyze a set of contagion-preventing policies in the appendix.

Keywords: Contagion, Network, Default, Cascade, DSGE, Interbank Market, Heterogenous Agents, Monetary Policy

JEL Classification: E44, E32, E52, E58, D85

Suggested Citation

Ferrari, Massimo, Contagion Along the Business Cycle (May 25, 2018). Available at SSRN: https://ssrn.com/abstract=3184887 or http://dx.doi.org/10.2139/ssrn.3184887

Massimo Ferrari (Contact Author)

Università Cattolica del Sacro Cuore (UCSC) ( email )

1 Largo A. Gemelli
Milano (Milan), MI Milano 20123
Italy

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