1. Financial market Frictions and
Real Activity

2. Trends in macroeconomics
• Very old macro
– financial sector plays a crucial role in large scale empirical
models
– largely based on “plausible” but ad hoc Tobin-type asset
demand functions
– US-based, banks play a role but direct capital market issues
more important
• old macro
– analyse the great moderation
– finance has disappeared completely from theory and empirics
• new macro
– end of the great moderation, rebirth of financial frictions
– banking sector fragility and the crises of 2007-….
– unconventional monetary policy
• QE
• direct intervention in segmented niche markets

3. Banking distress and real economic activity
of course there is a causality issue…

4. Leverage plays a role?

5. New Macro: re-introduce financial sector
into macroeconomics
• Existing models have frictionless capital markets (e.g.
Smets/Wouters)
• First Generation friction models introduce “financial
accelerator”
– bernanke/Gertler/Gilchrist, based on CSV (Townsend (1979))
– frictions only on non-financial firms
– intermediaries “typically just a veil” (quote Gertler)
– only consider conventional monetary policies
– Lagarde’s “chains of contagion” play no role

6. A flight from risk

7. But situation in France, Germany, UK…
(Lagarde’s chains of contagion)
Greece Ireland Portugal Spain Italy
Germany 36.8 138.6 37.2 181.6 153.7
France 53.5 50.1 41.9 162.4 418.9
UK 12 148.5 22.4 110.8 66.8
Netherlands 4.7 21.2 5.1 72.7 43.2
Spain 78.3
December 2010: European Bank Exposure (bE) to the debt of:

8. Interbank counterparty worries are back

9. Bank interventions transferred risks to public
sector

10. 2nd
generation new macro
• Banking sector itself the source of financial frictions
– Gertler/Karadi: costly enforcement
• endogenizes banking sector leverage
• interior solution based on capital market participation constraint
– Kirchner/van Wijnbergen
• extends GK: portfolio choice banks between corporate & sovereign
bonds/loans
• this way introduces new crowding out mechanism
– vdKwaak/van Wijnbergen
• introduce long maturity Government debt (important for Lagarde
mechanism)
• introduce sovereign default possibility (interaction weak banks-weak
sovereigns)
– shortcoming GK approach: defaults actually do not occur
• loan contracts are really equity contracts

11. Alternative/complementary approaches
• based on debt overhang and possibility of private default
– Ochini/Pescatori (2011)
– note differences in contractual assumptions with
Bernanke/Gertler/Gilchrist
• modeling interbank markets
• macroprudential issues
– macro consequences of structure of banking regulation
– consequences of interconnectedness of banking system
• correlated risks and macro crises
• Lagarde’s chains of contagion
• Caballero: collateral constraints and segmented markets
• Brunnermeijer/Sannikov: asset prices in macroeconomics

12. Starting point Bernanke/Gertler
• Asymmetric information (costly state verification) and/or
costly contract enforcement cause financial frictions
• causes an external finance premium
• Balance sheet structure matters for external finance
premium
– deviations from MM

13. Basic environment
• two periods: 0 and 1
• RN entrepreneur: project requires funding in 0 and pays
off in 1
• competitive RN lender, opportunity cost of funds R
– depositors have “safe” alternative
• Project financing mix: QK=N+B
– K capital input
– N equity (entrepreneur’s net worth)
– B debt finance
• Note contractibility of investment effort

14. Basic Environment (cont.)
• period 1 pay off:
– since E =1, entrepreneur operates if Rk>R
• perfect information/perfect contract enforcement:
– MM applies
– investment independent of financial structure
– competitive equilibrium enforces Rk=R
• But with private information and limited liability:
– only entrepreneur can costlessly observe returns
– lenders pay monitoring costs
– entrepreneur’s pay off bounded at zero (Limited Liability)
– entrepreneur has incentive to misreport ω
– design contract to induce truth telling (revelation principle)
.kR QKω%
ω%
kR Kµω

15. Basic Structure
• entrepreneur chooses K, contractible
• financial contract payment schedule based on ω and
decision to monitor
• lender must receive opportunity cost in expectation
(Capital Market Participation Constraint for RN lender)
• structure of optimal contract has option characteristics
– lender’s pay off:
– deadweight bankruptcy costs:
• Only entrepreneur costlessly observes , Bank pays
monitoring cost 
*
min ( ,(1 ) ) kR QKω φ ω−
kR QKφω

16. Contract
• Note entrepreneur’s incentive to misrepresent outcome
• Constraints: lender’s CMPC, truthtelling by entrepreneur
must be incentive compatible
• If  > *,
– L receives *RKQK
– E (- *) RKQK
• If  < *,
– E announces default, L monitors
– Lender receives (1-) RKQK
• Deadweight costs RKQK, triggers failure of MM
• No incentive to lie

17. Contract outcomes
• Bankruptcy probability:
– H cdf , h corresponding pdf
– note HD>0
• Lender’s expected gross payment:
• Note: ’ > 0, ’’ < 0
• Lender’s exp. pymnt net of monitoring costs:
– RkQK(Γ(ω*)-μG(ω*))
– with
– Monitoring only in the bad state of nature
*
( ) ( )
k
D
H H
R QK
ω =
*
*
* *
( )dH dH
ω ω
ωω
ω ω ω+ ≡ Γ∫ ∫
*
G( *) d
w
w
=w w wò

18. Entrepreneur’s optimization problem (cont.)
*,
*,
(1)max{max((1 ( *)) ,0)}
subject to lender's participation constraint :
(2) ( ( *) ( *)) ( )
Combine equations (1,2) to get:
(3)max{max(( ( *) ) ,0)}
k
K
k
k k
K
R QK RN
G R QK R QK N
R R G R QK
ω
ω
ω
ω µ ω
µ ω
− Γ −
Γ − = −
− −

19. capital demand, balance sheet structure and
the spread
( ) , ' 0
( )
:
( )
k
k
k
R
QK N
R
R
leverage ratio
R
can be inverted
R QK
R N
φ φ
φ
χ
= >
=
• So in equilibrium, spread is inversely related to aggregate
balance sheet strength
•Information problems, monitoring costs cause a deviation from
MM

20. Move to general equilibrium
• Endogenise finance premium Rk/R, net worth N and price
of capital Q
• Financial accelerator =>
– procyclical movements in N => countercyclical movements in Rk/R
– movements in Q induce movements in N => feed back between
real/financial sector
• Financial crisis
– sharp drop in N
– tightening net worth constraint
– rising external finance premium