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The long-run effects of risk: an equilibrium approach

Joao Madeira (), Nuno Palma and Christiaan van der Kwaak

No 15841, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Advanced economies tend to have large but unstable intermediation sectors. We employ a DSGE model with banks featuring limited liability to investigate how risk shocks in the financial sector affect long-run macroeconomic outcomes. With full deposit insurance, banks expand balance sheets when risk increases, leading to higher investment and output. With no deposit insurance, we observe substantial drops in long-run credit provision, investment, and output. These differences provide a novel argument in favor of deposit insurance. Finally, our welfare analysis finds that increased risk reduces welfare, except when there is full deposit insurance and deadweight costs are small.

Keywords: Costly state verification; deposit insurance; endogenous leverage; intermediation; investment; limited liability; Regulation; risk (search for similar items in EconPapers)
JEL-codes: E22 E44 G21 O16 (search for similar items in EconPapers)
Date: 2021-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cwa, nep-dge, nep-fdg, nep-ias and nep-mac
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