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The adverse feedback loop and the effects of risk in both the real and financial sectors

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  • J. Scott Davis
Abstract
Recessions that are accompanied by financial crises tend to be more severe and are followed by slower recoveries than ordinary recessions. This paper introduces a new Keynesian model with financial frictions on both the demand and supply side of the credit markets that can explain this empirical finding. Following a shock that leads to a decline in economic activity, an adverse feedback loop arises where falling profits and asset values lead to increased defaults in the real sector, and these increased defaults lead to increased loan losses in the banking sector. Following this increase in loan losses, financial frictions in the banking sector imply that the banking sector itself may face difficulty obtaining funds. This disruption in the intermediation process leads to a further decline in output and asset prices in the real sector. In simulations of the model it is found that this feedback loop operating through the balance sheets of financial intermediaries can lead to as much as a 20 percent increase in business cycle volatility, and impulse response analysis shows that in the presence of financial frictions the path back to the steady state after a shock is much slower.

Suggested Citation

  • J. Scott Davis, 2010. "The adverse feedback loop and the effects of risk in both the real and financial sectors," Globalization Institute Working Papers 66, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddgw:66
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    7. J. Scott Davis & Kevin X. D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization Institute Working Papers 85, Federal Reserve Bank of Dallas.
    8. Uluc Aysun, 2013. "Bank size and macroeconomic shock transmission: Are there economic volatility gains from shrinking large, too big to fail banks?," Working Papers 2013-02, University of Central Florida, Department of Economics.
    9. Mark A. Wynne, 2012. "Five Years of Research on Globalization and Monetary Policy: What Have We Learned?," Annual Report, Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas, pages 2-17.
    10. Hibiki Ichiue & Jean-Guillaume Sahuc & Yasin Mimir & Jolan Mohimont & Kalin Nikolov & Olivier de Bandt & Sigrid Roehrs & Valério Scalone & Michael Straughan & Bora Durdu, 2022. "Assessing the Impact of Basel III: Evidence from Structural Macroeconomic Models," Working Papers hal-04159816, HAL.
    11. Hristov, Nikolay & Hülsewig, Oliver, 2017. "Unexpected loan losses and bank capital in an estimated DSGE model of the euro area," Journal of Macroeconomics, Elsevier, vol. 54(PB), pages 161-186.
    12. Aysun, Uluc, 2024. "Technology diffusion and international business cycles," Journal of International Money and Finance, Elsevier, vol. 140(C).
    13. Dungey, Mardi & Islam, Raisul & Volkov, Vladimir, 2020. "Crisis transmission: Visualizing vulnerability," Pacific-Basin Finance Journal, Elsevier, vol. 59(C).
    14. Kuang-Liang Chang & Nan-Kuang Chen & Charles Ka Yui Leung, 2016. "Losing Track of the Asset Markets: the Case of Housing and Stock," International Real Estate Review, Global Social Science Institute, vol. 19(4), pages 435-492.
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    Keywords

    Business cycles - Econometric models; Financial markets; International finance; Financial crises; Recessions;
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