Abstract
The purpose of this study is to clarify the mechanism of financial friction in a simple two-period model, which is a two-period version of the Gertler-Kiyotaki model, in an attempt to enhance understanding of financial instability. Our focus is on financial firms’ balance sheet channel of transmission of adverse shocks when an incentive constraint is present in financial intermediary firms and/or production firms. In this paper we show that the larger positive premium equilibrium reflects the extent of inefficiency in a financial market through the structure of incentive constraint and the size of net worth. Further we argue that the existence of a positive premium in our model depends on the relation between two factors in states space: the degree of pledgeability or lack of a commitment of financial firm/bank toward investors, as well as the state of net worth of the financial intermediary.
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