Aurora Borealis
1 October 2014 CFA Institute Journal Review

Financial Crises and Economic Growth (Digest Summary)

  1. Jennie I. Sanders, CFA

Financial crises and economic growth are modeled to show how financial markets affect economic activity in two types of environments: a normal equilibrium and a no-lending equilibrium. The author uses the model to understand the impact of various government policies in a normal environment and an environment in which banks are not lending and firms are not able to borrow.

What’s Inside?

The author studies the relationship between financial crises resulting from systemic defaults and real economic growth by examining the aggregate production function for the economy, aggregate consumption, the financial sector, and a normal equilibrium versus a no-lending equilibrium. Monetary policy will not affect investment or borrowing in a no-lending equilibrium but may lead to a normal equilibrium.

How Is This Research Useful to Practitioners?

Practitioners may find this research useful when seeking a theoretical explanation for such economic environments as occurred in 2007, when monetary policy had little impact on economic growth.

The effectiveness of government policies is contingent on the equilibrium assumed. In a normal equilibrium, output and capital will grow as investment in firms grows. An increase in the expected growth rate of capital or a decline in the equilibrium loan rate will lead to an increase in investment. In a no-lending equilibrium, the zero lending rate needs to be lowered or the zero borrowing rate needs to be increased to return to a normal equilibrium. The lending rate is lowered by reducing the riskless rate or increasing bank capital (as the need to borrow declines). The zero borrowing rate is increased by reducing firm capital or increasing expected output.

Once a normal equilibrium is regained, a decrease in the real value of government debt resulting from an increase in the money supply causes the equilibrium riskless rate and loan rate to decline, leading to an increase in investment. The impact of fiscal policy is similar to that of monetary policy in a normal equilibrium and leads to an increase in the zero borrowing rate in a no-lending equilibrium, which may lead back to a normal equilibrium. Bank regulation is measured by studying the risk measure; increasing the risk measure leads to fewer loans, an increased lending rate, and a decrease in the riskless rate in a normal equilibrium and to an increase in the zero lending rate in a no-lending equilibrium. Restrictions on banks tend to prevent a reversal of a no-lending equilibrium. Governments can also add capital to the banking sector and to firms in an attempt to reverse the no-lending condition, but such action decreases the zero borrowing rate and prolongs the no-lending condition because the need for firms to borrow decreases.

How Did the Author Conduct This Research?

The author constructs the model assuming continuous time with an infinite time horizon, an economy with no currency, and capital as the only real commodity. He assumes that there are three entities—firms, banks, and a government—that consume and produce capital. Firms own the risky production technology, and the government owns the riskless production sector. Fiscal policy is captured by the amount of capital borrowed by the government. Monetary policy is captured as expressed by the changes in the real value of government debt. Fiscal and monetary policy may crowd out private loans in a normal equilibrium but had little effect on the investment and borrowing decisions of firms in a no-lending equilibrium.

A financial crisis can occur only if the economy is in a normal equilibrium, causing a shift to the no-lending equilibrium, which requires that illiquid capital be reallocated. A normal equilibrium reveals borrowing and lending at loan rates above the riskless rate, and a no-lending equilibrium reveals no borrowing or lending, no equilibrium loan rate, and an indeterminable riskless rate. Firms are not willing to pay the rate needed for banks to lend. The shift to a no-lending equilibrium occurs because bankruptcies remove capital from the economy, unemployment is likely to increase, both firms and banks lose confidence, and banks become more risk averse.

The author assumes that firms are leveraged and banks are not but suggests that leveraged firms could include investment banks and divisions within commercial banks. Currency would need to be factored into the model to separately study the impact of fiscal policy.

Abstractor’s Viewpoint

This research suggests that a normal equilibrium is required before government policies can affect investment decisions and discusses the variables that may influence a reversal from a no-lending equilibrium to a normal equilibrium. Empirical data would further enhance the research on the inputs that affect the no-lending equation.

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