Financial Intermediation, Leverage, and Macroeconomic Instability

Gregory Phelan

American Economic Journal: Macroeconomics, 2016, vol. 8, issue 4, 199-224

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.

JEL-codes: E32 E44 G01 G21 (search for similar items in EconPapers)
Date: 2016
Note: DOI: 10.1257/mac.20140233
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Citations: View citations in EconPapers (21)

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