Bank Capital, Credit Market Frictions and International Shocks Transmission

Abstract

Recent empirical evidence suggests that the state of banks’ balance sheets plays an important role in the transmission of monetary policy and other shocks. This paper presents an open-economy DSGE framework with credit market frictions and an active bank capital channel to assess issues regarding the transmission of domestic and foreign shocks. The theoretical framework includes the financial accelerator mechanism developed by Bernanke et al. (1999), the bank capital channel and the exchange rate channel. Our simulations show that the exchange rate channel plays an amplification role in the propagation of shocks. Furthermore, with these three channels present, domestic and foreign shocks have an important quantitative role in explaining domestic aggregates like output, consumption, inflation and total bank’s lending. In addition, results suggest that economies whose banks remain well-capitalized when affected by adverse shock experience less severe downturns. Our results highlight the importance of bank capital in an international framework and can be used to inform the worldwide debate over banking regulation.