Abstract

We build a dynamic general equilibrium model that adds a banking sector to the standard RBC model. We look at the response of the real interest rate to innovations in the banks' technology and in the nonbank firms' technology. While technological innovations in the nonbanking sector put upward pressure on the interest rate, technological innovations in banks exert downward pressure on the interest rate. This implies that, if the technological innovations in banks are strong enough, stochastic simulation experiments generate negative correlations between the real interest rate and current and future values of real output. This is especially significant because negative correlations between the interest rate and output are a key post-war U.S. business cycle fact difficult to replicate in benchmark dynamic models.

Highlights

  • A key post-war U.S business cycle fact is the negative correlation between the real interest rate and real output (King and Watson, 1996)

  • In this paper we look at the behaviour of the nominal interest rate in a world where there are technological innovations that are specific to the banking industry as well as technological innovations in nonbank firms

  • The nominal interest rate charged by the banks has to adjust so as to make the marginal product of labour (MPL) in banks equal the real wage at the point that corresponds to the amount of hours of work that banks need in order to be able to supply the real amount of credit that is being demanded. keywords: Dynamic General Equilibrium Models, Inside Money, Cash-in-Advance, Technological Innovations

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Summary

Introduction

A key post-war U.S business cycle fact is the negative correlation between the real interest rate and real output (King and Watson, 1996). The impulse response experiments we performed with our model show that whereas positive shocks in the nonbank firms technology make the real interest rate go up, positive shocks in the banks technology make the real interest rate fall This implies that, if the technological shocks in banks are strong enough, stochastic simulations of our model generate negative correlations between the real interest rate and current and future values of real output - the key post-war business cycle fact difficult to reproduce in model economies. This result is relevant because technological innovations over the past few decades have affected the banking industry with special intensity.

The Economic Environment
The Behaviour of Banks and Firms
The Typical Household’s Behaviour
Market Clearing Conditions and the Competitive Equilibrium
Calibration
The Dynamic Properties of the Model
Technological innovations in nonbank firms
Technological innovations in both sectors
Response to a shock in the banks’ technology
Technological innovations bigger in the banking sector
Stochastic simulation with shocks in both sectors
Findings
Conclusion
Full Text
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