Project Summary: The intellectual merit of this project involves the continuing development of macroeconomic models that capture the interaction between the financial and real sectors. The long term goal is to develop a framework that can (i) capture financial crises of the type that recently unfolded (ii) characterize how the "unconventional" credit market interventions by the Federal Reserve and the Treasury may have worked to stabilize the economy;(iii) explore the incentives for risk-taking that these policies may have induced; and (iv) assess the desirability of "macroprudential" policies aimed at reducing the threat of a future financial crisis. Further, the plan is to not only develop qualitative insights but also to develop a framework that is useful for quantitative analysis. The approach builds on Gertler and Karadi (GKa 2010) and Gertler and Kiyotaki (GKi 2010). This work incorporates a banking sector within a standard quantitative macroeconomic model. Key to motivating a crisis within these frameworks is the heavy reliance of banks on short term debt. This feature makes these institutions highly exposed to the risk of adverse returns on their portfolio in way that is consistent with recent experience. Within these frameworks and most others in this class, however, by assumption the only way banks can obtain external funds is by issuing short term debt. The first step in this project will be to enrich the portfolio decisions of banks by permitting additional instruments to hedge risks (e.g. new equity issues, etc.). Here the goal is to have a model that can not only capture a crisis when financial institutions are highly vulnerable to risk, but also account for why these institutions adopt such risky portfolio structure in the first place. The second step will then be to study how the "unconventional" credit market interventions of the last several years may have affected banks' portfolio decisions. Both GKa and GKi study how these policies helped stabilize the economy. However because they considered a framework with a very simple bank liability structure, they did not capture the possible effects of these policies on banks risk-taking incentives. With this new framework it will be possible to capture quantitatively the "moral hazard" consequences of these policies. The third step then is to extend the framework to consider macroprudential policies such as capital and liquidity requirements that are aimed to curtail bank risking taking. The broader impact of the project will involve use by practitioners (e.g. central banks) of the frameworks developed to study unconventional and macroprudential policies.
