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Small DSGE Model with Financial Frictions

Melesse Wondemhunegn Ezezew ()
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Melesse Wondemhunegn Ezezew: Department of Economics, University Of Venice C� Foscari

No 2015:20, Working Papers from Department of Economics, University of Venice "Ca' Foscari"

Abstract: In the last few years, macroeconomic modelling has emphasised the role of credit market frictions in magnifying and transmitting nominal and real disturbances and their implication for macro-prudential policy design. In this paper, we construct a modest New Keynesian general equilibrium model with active banking sector. In this set-up, the financial sector interacts with the real side of the economy via firm balance sheet and bank capital conditions and their impact on investment and production decisions. We rely on the financial accelerator mechanism due to Bernanke et al. (1999) and combine it with a bank capital channel as demonstrated by Aguiar and Drumond (2007). We calibrate the resulting model from the perspective of a low income economy reflecting the existence of relatively high investment adjustment cost, strong fiscal dominance, and underdeveloped financial and capital markets where the central bank uses money growth in stabilizing the national economy. Then we examine the impulse response of selected endogenous variables to shocks stemming from the fiscal authority, the monetary policy process, and technological progress. The findings are broadly consistent with previous studies that demonstrated stronger role for credit market imperfections in amplifying and propagating monetary policy shocks. Moreover, we also compare the trajectory of the model economy under alternative monetary policy instruments. The results suggest that the model with money growth rule generates higher volatility in output and inflation than the one with interest rate rule.

Keywords: Firm net worth; bank equity; monetary policy transmission; macro-prudential regulation; business cycle (search for similar items in EconPapers)
JEL-codes: E32 E44 E50 C68 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-fdg, nep-mac and nep-mon
Date: 2015
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