Contagion Along the Business Cycle

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