Cascades Along the Business Cycle

Abstract

Abstract In this paper, we incorporate a complex network model into a standard stochastic general equilibrium framework with an active interbank market. On this market banks exchange funds one another giving rise to a complex network of interbanking relations. With the tools of network analysis we are able to study how contagion spreads between banks and what is the probability and size of a cascade of defaults following a single initial episode. These two variables are a key component of systemic risk and are fundamental to assess the stability of the banking system. In extreme situation, the system may experience a phase transition when the consequence of one single initial shock affect the entire population. Finally, we provide simulations to show how the size and probability of a cascade evolve along the business cycle and how they respond to exogenous shocks. We find that monetary policy present a trade off between output and financial stability. Government spending shocks have smaller effects on output, but affect less the cascade probability.