The Banking Crisis as Dynamic Stochastic General Equilibrium

Abstract

Crises are triggered by the inherent uncertainty of the capitalist system. We represent this uncertainty in an open economy real business cycle model of the UK by including non-stationary productivity shocks. A random sequence of good or bad shocks will accumulate, producing euphorias and crises; banking crises will be superimposed when banks have been sucked in by a euphoria. Existing macro models can also help to understand the macro effects of a banking crisis and to calibrate the necessary policy responses, even if they cannot explain the crisis shock itself; we illustrate this from DSGE models of the EU and the US. In designing new regulative systems we need to avoid throwing the capitalist baby out with the risky bathwater.