Risk Dynamics with Heterogeneous Borrowers and Intermediaries
50 Pages Posted: 25 Jan 2021
Date Written: November 2020
This paper studies the effects of borrowers' balance sheet heterogeneity on economywide risks and fragility, together with effects from intermediary balance sheet channel. We build a continuous time heterogeneous agents model with financial frictions and analytically characterize the transition dynamics. Once the economy moves to high leverage states, it tends to stay there — a leverage trap. Transition speed increases (decreases) when the economy is leveraging up (deleveraging) and when interest rate is lower. Tail uncertainty lasts longer during transition. Intermediary failure risk can lead to severe decline in borrowing/lending activities that could further slow the recovery process.
Keywords: heterogeneous agents, financial fragility, transition dynamics, debt distribution, intermediary failure risk, systemic risk
JEL Classification: E44, G20, G10
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