The Domestic and the International E¤ects of Financial

Disturbances �

Fabio Canova, Leonor Coutinho, Caterina Mendicino,

Evi Pappa, Maria Teresa Punzi and Domink Supera

European University Institute

February 11, 2015

Abstract

We construct a two country dynamic stochastic general equilibrium model to ana-

lyze the domestic and international propagation of disturbances that a¤ect the lend-

ing/borrowing capabilities of agents. One country represents the periphery of the Euro

area; the other the rest of the Euro area. We show that all disturbances generate impor-

tant �nancial cycles and deep global recessions, accompanied by a fall in�ation, in the

policy rate, and in house prices. All disturbances signi�cantly a¤ect the balance sheet

of the banking system, worsen the external position of the domestic country, and greatly

increase domestic government debt. We examine whether prudential regulations may help

to reduce the �nancial volatility, the negative real e¤ects and improve welfare.

February 11, 2015

JEL Classi�cation: E32, F41, G21.

Key words: Financial shocks, international transmission, prudential policies, welfare analy-

sis.

�This research is funded by the European Commission, DG EcFin (tender reference: ECFIN 2013 008/E

- OJEU 2013/S112-190350). Comments and suggestions by sta¤ members of DG EcFin are gratefully

acknowledged

1 Introduction

The 2008-2009 �nancial crisis and the ensuing European debt crisis have highlighted the

importance of accounting for the links between the �nancial sector, the macroeconomy and

government debt. Policymakers were unable to understand the factors that led to the twin

crises and their consequences because macroeconomic models paid little attention to �nancial

variables as originators of shocks. Recent empirical evidence indicates that ignoring �nancial

disturbances may induce important distortions in the interpretation of economic �uctuations.

For example, according to Hubrich et. al., 2013, shocks to Euro area �nancial variables

(which include disturbances to real stock prices, to real house prices, to the term spread,

to loans, and to banks� loans-to-deposit ratio) account for about 33% of the forecast error

variance decomposition of output at the three year horizon, on average over the last twenty

years. In comparison, monetary policy shocks account for about 10% of the forecast error

variance decomposition of output at the same horizon and �scal shocks for about 15%.

Similarly, Gilchrist, Yankov and Zakrasjek (2009) show that ��nancial factors�shocks

explain about 30 percent of US output and in�ation �uctuations at the two years

horizon; while Gilchrist and Zakasjek (2012) show that, consistent with the theories put

forward by Bernanke, Gertler and Gilchrist (1999), Gertler and Karadi (2011) and Gertler

and Kiyotaki (2010), widening credit spreads are causally associated with a worsening of

private agents balance sheets and a drop in real activity. On the other hand, Mian and

Su� (2014) show that the so-called �household net worth channel� is largely responsible for

the fall in aggregate employment in the US during the 2007 -2009 period.

Thus, abstracting from the �nancial disturbances may overestimate the contribution of,

say, productivity or terms of trade shocks, and incorrectly representation of the transmission

mechanism of economic �uctuations. In addition, closed economy models are likely to give an

incomplete view of �nancial shocks, since second round cross-country e¤ects are disregarded.

1.1 The content of this paper

This paper constructs a two-country, large scale, dynamic stochastic general equilibrium

(DSGE) model, with interactions between the �nancial sector and the macroeconomy, and

cross country linkages via trade and �nancial �ows. We examine the domestic and interna-

2

tional transmission of �nancial disturbances that a¤ect the borrowing and lending abilities

of domestic agents and the role that �nancial constraints play in propagating these shocks.

We focus attention on four separate issues. First, we want to examine whether �nancial

shocks originating in di¤erent sectors of the economy generate di¤erences in terms of depth

of the recessions, the persistence of the real e¤ects, and the domestic transmission properties.

Second, we wish to highlight the channels through which �nancial disturbances a¤ect foreign

real economic activity. Third, we are interested in identifying the structural parameters that

may be crucial in determining the dynamics of the endogenous variables. Fourth, we want

to study whether prudential policies can reduce the amplitude and the persistence of the

�nancial cycle, limit real consequences, and improve welfare.

1.2 A stylized description of the model

In the model there are borrowing and lending households; borrowing entrepreneurs; a

vertically integrated sector producing �nal non-durable goods; house producers; retail and

investment banks; a �scal authority in each country and a common monetary authority.

Domestic lending households deposit their savings in domestic retail banks which use

them to lend to domestic borrowing households and to the global interbank market.

Domestic investment banks borrow from the interbank market to �nance the activities of

domestic borrowing entrepreneurs and to purchase a portfolio of government bonds. House

producers augment the stock of houses that households hold; houses provide a service

�ow and a store of value, and are non-traded across countries. The vertically integrated

production sector takes goods produced by entrepreneurs and transform them into bundles

of �nal goods, consumed by the household, the government, or used for investment. There

is international trade of intermediate goods; �nal goods are non-tradable. The �scal

authority �nances a budget de�cit by issuing one period bonds; the monetary authority

sets the nominal interest rate as a feedback rule of area wide variables.

1.3 A summary of the results

When calibrated to produce a domestic credit contraction, all shocks produce deep output

recessions, accompanied by a signi�cant contraction of private demand; by a fall in house

3

prices and housing demand; by a signi�cant and persistent decline in in�ation and in banks�

intermediation activities. Furthermore, the e¤ects are global. Some shocks redistribute

resources between borrowers and lenders; others, redistribute resources across countries

leading, after a few periods to an export-led domestic recovery. The sector where the

disturbances occur is irrelevant because all shocks contract the lending market.

All shocks we analyze are transmitted, domestically, via loans and deposits markets and,

internationally, via trade and the interbank market. The changes in loans and deposits rates

and houses prices contract the time pro�le of income of households either within a country

or across countries and lead to important output adjustments. All shocks worsen the

short run domestic external position and expands domestic government debt, as the cost of

�nancing greatly increases. Furthermore, since sovereign spreads increase, these shocks have

implications for public debt management.

The qualitative features of the transmission are generally robust. The parameters regu-

lating the �nancial constraints a¤ect �nancial and real cycles di¤erently, but the e¤ects on

real �uctuations are small. For disturbances originating in the banking sector, the e¤ects

of altering crucial parameters are larger but the direction of the changes for real variables

depends on the type and the branch of the banking sector where the shock originates.

Prudential actions by the monetary authority are as good as cyclical capital bu¤ers in

smoothing out the �nancial cycle and in reducing the real e¤ects. However, to understand the

consequences that prudential policies have, one needs to know the type of the shock and the

sector in which the shock occurs. Prudential policies generally produce a redistribution of

the losses across agents within a country or across countries and may lead to interesting

political economy trade-o¤s. Given that prudential policies are not generally designed with

welfare purposes in mind, our analysis suggests that they should be used in conjunction

with redistributive �scal policies (see e.g. Jeanne and Korinek, 2013), if they are to produce

Pareto improving allocations along the adjustment path.

1.4 Related literature

Four di¤erent strands of recent literature relate to the work we do. The �rst tries to

understand the supply side of the credit market, see e.g. van der Heuvel (2008), Curdia

4

and Woodford (2009), Angeloni and Faia (2009), Brunnermaier and Sannikov (2010), Kiley

and Sim (2011), Meh and Moran (2010), Gertler and Karadi (2011), Gertler and Kiyotaki

(2010), Jerman and Quadrini (2012), or Williamson (2012).

The second explicitly incorporates a banking sector in standard macroeconomic models,

see e.g. Gerali et al. (2010) , Dib (2010) and Kollmann et al. (2013). In these models, the

presence of balance sheet constraints establishes a link between credit supply and the business

cycle. Business cycle �uctuations a¤ect banks�pro�ts and therefore bank capital. In turn,

because of capital constraints, changes in bank capital alter the supply and the cost of loans,

therefore reinforcing the e¤ects of the original shocks. Within this literature, the paper

closest in spirit to what we do is Iacovello (2013). He studies the e¤ect that shocks

disrupting the �ow of funds between di¤erent agents have on the domestic business cycles.

A third strand of literature modelled demand for housing to capture the need for long-

term �nancing on the part of households, via collateral and value-to-loan constraints, see,

among others, Iacoviello and Neri (2010), and Lambertini, Mendicino, and Punzi (2013).

The presence of housing markets allows researchers to model waves of optimism regarding

house price appreciation, which can lead to excessive leveraging on the part of households

(see e.g. Gelain, Lansing, and Mendicino, 2012).Within the literature, Adam, Kuang, and

Marcet, (2011); Ferrero, (2012) highlighted the connections between house price appreciation

and current account de�cits; and Cao and Le Hullier (2013) that the news-noise confusion

about future fundamentals can exacerbate leveraging e¤ects.

Most of the models take a closed economy perspective. Those papers who have explicitly

modelled credit supply and their disruptions in an international dimension, e.g. Devereux

and Yetman (2010) , Mendoza and Quadrini (2010), Kollman, et al. (2011) Guerrieri et al.

(2012), Ueda (2013) have borrowing constraints in only one sector of the economy and are

not rich enough to study channels of international propagation of shocks.

The �nal line of research linked to our papers examines macro-prudential policies.

These have been analyzed in models where moral hazard may incentivate banks to engage

in investments which are too risky from a social point of view, see e.g. Begenau (2013), Rios

Rull, Takamura and Terajima (2013) , Nguyen (2013), Jeanne and Korinek (2013) or where

there are pecuniary externalities, see Gersbach and Rochet (2013). Some papers have also

5

addressed the issue of designing capital/ liquidity requirements under �re sales, see e.g. Kara

and Ozsoy (2014), and show that the pre -Basel III regulatory framework is inferior in terms

of allocations of the joint regulation of capital and liquidity.

Our model combine aspects of existing models to study the propagation of �nancial

shocks occurring in di¤erent sectors of the domestic economy using general equilibrium and

open economy perspective. Contrary to the existing literature we construct a rich setup

with trade in goods and �nancial assets, which can be used to answer a number of

interesting policy questions. Moreover, we explicitly evaluate the usefulness of prudential

policies in stabilizing the economy and improving welfare.

2 The model economy

The model has two countries: the domestic country captures an economy belonging to the

Euro area periphery; the foreign country the rest of the Euro area. The two economies di¤er

in size (0 < n < 1 is the size of the domestic economy), but they are symmetric in terms of

preferences and technologies. Foreign variables are denoted by the superscript �.

Each country is populated by patient and impatient households, by non-�nancial �rms,

and by banks. The government consumes goods and �nances expenditures with taxes and

debt. A single central bank setting the policy rate as a feedback rule of the average CPI

in�ation and of the average output in the two economies.

We describe the building blocks of the model for the domestic country. Because of

symmetry, the foreign block is obtained by adding the superscript � to the variables.

2.1 Households

Households work, consume, buy real estate, and decide on their �nancial position. Patient

households, indexed by s 2 [0; !sn], 0< !s < 1; have a higher discount rate than impatient

households, indexed by b 2 (!sn; n]; �s > �b: Because of the di¤erent propensity to save,

in the equilibrium we consider, the former save while the latter borrow. Housing is a durable

good, non traded internationally, which depreciates over time and its demand depends

on both the �ow of services it provides and its asset value. Impatient households, which will

6

be credit constrained in equilibrium, collateralize the value of their houses. Household takes

prices, the interest rate on deposits and loans, and the nominal wage parametrically.

2.1.1 Patient Households

The representative patient household chooses Cs;t; consumption, Hs;t; housing, Ns;t, hours

worked, and Ds;t, bank deposits, to maximize her expected lifetime utility:

maxfCs;t;Hs;t;Ns;t;Ds;tg

E0

1Xt=0

�ts

"(Cs;t � hCs;t�1)1��

1� � + "ht �hs

H1��s;t

1� � � �ns

N1+'s;t

1 + '

#; (1)

where "ht is a housing preference shock, �hs > 0 and �ns > 0 govern the utility of housing

services and hours worked, respectively, 0 < �s < 1, '�1 > 0 is the Frish elasticity of labor

supply; � > 0 is the coe¢ cient of relative risk aversion and 0 � h � 1 controls habits in

consumption. The maximization is subject to the sequence of budget constraints:

Pt(Cs;t+Ts;t+ACHs ;t)+PHt [Hs;t�(1� �H)Hs;t�1]+Ds;t = Rs;t�1Ds;t�1+WtNs;t+DIVs;t (2)

where Pt is the price of consumption, Ts;t are real lump-sum taxes, PHt is the price of hous-

ing, �H is the housing depreciation rate, Rs;t�1 is the gross nominal rate on deposits, Wt

is the nominal wage, DIVs;t are nominal dividends from �rms and banks, owned by patient

households; and ACHs ;t are real external adjustment costs of changing the housing stock:

ACHs ;t =sHs2

�Hs;tHs

� 1�2

Hs (3)

where Hs is the steady state stock of housing of patient households, and sHs � 0.

2.1.2 Impatient Households

The representative impatient household chooses cb;t consumption, Hb;t housing, Nb;t hours

worked, Lb;t bank loans to maximize her expected lifetime utility:

maxfCb;t;Hb;t;Nb;t;Lb;tg

E0

1Xt=0

�tb

"(Cb;t � hCb;t�1)1��

1� � + "ht �hb

H1��b;t

1� � � �nb

N1+'b;t

1 + '

#; (4)

subject to the sequence of budget constraints:

Pt(Cb;t+Tb;t+ACHb;t)+P

Ht (Hb;t� (1� �H)Hb;t�1)+Rb;t�1Lb;t�1�Pt"bt = Lb;t+WtNb;t (5)

7

where �hb > 0 and �Lb > 0 govern the utility of housing services and hours worked, 0 < �b < 1,

Rb;t�1 is the nominal interest rate on loans, and Tb;t are real lump-sum taxes. "bt � 0 is a

default shock and captures the idea that borrowers may increase their consumption by paying

back domestic lenders less than contractually agreed, Rb;t�1Lb;t�1;see also Iacoviello (2013);

ACHs ;t are real external adjustment costs of changing the housing stock, given by:

ACHb;t =

sHb2

�Hb;tHb

� 1�2

Hb (6)

where Hb is the steady state stock of housing held by patient households, and sHb � 0.

Impatient households need to post a collateral to obtain loans. Due to transactions,

repossession and selling costs, we assume that only domestic banks lends to domestic

agents. New loans are restricted to be proportional to the expected discounted value of the

housing wealth of borrowers, adjusted by the default shock:

Lbt � �b�tLbt�1 + (1� �b) btEt

PHt+1 (1� �H)Hb;tRb;t

� Pt"bt

!; (7)

where 0 < bt = b0��bt < 1 is the equity requirement or loan-to-value (LTV) ratio;

b0 measures

the degree of household loans market tightness; the valuation shock "�bt captures subjective

lenders perceptions of the riskiness of the housing wealth. Implicit in (7) is the assumption

that lenders are aware that borrowers may pay less than contractually agreed and take that

into account when valuing the housing collateral. The parameter 0 � �b � 1 allows for inertia

in the adjustment over time of the borrowing constraint.

2.2 Entrepreneurs

A continuum of upstream �rms, indexed by e 2 [0; n], own a production technology and

capital, borrow to �nance production and post a collateral to obtain a loan, buy investment

goods and produce an homogeneous good using labor and capital. Investment goods are

turned into productive capital with one period time delay subject to adjustment costs.

Upstream �rms are owned by patient households, but managed by entrepreneurs. We in-

troduce a standard corporate �nance principal-agent friction by assuming that entrepreneurs

discount the future at a faster rate than patient households, �e < �s, because the horizon of

the entrepreneurs�problem may be shorter than the one of the �rm�s owner.

8

The representative entrepreneur takes the price of her output, PXt ;the price of investment,

Pt;the cost of borrowing and the nominal wage parametrically and chooses how much to

borrow, Le;t; how much to invest in productive capital, Ie;t, and how much capital, Ke;t and

labour Le;t to employ in production to maximize:

maxfLe;t;Ie;t;Ke;t;Ne;tg

E0

1Xt=0

�te�s;t[e;t] (8)

where

e;t = PXt Xe;t + Le;t � (PtIe;t +Re;t�1Le;t�1 � Pt"et +WtNe;t) (9)

�s;t is the marginal utility of one unit of dividends for patient households, "et � 0 is a

default shock which allows entrepreneurs to increase their dividend stream e;t by paying

back to the banks less than what is contractually agreed,Re;t�1Le;t�1:Xe;t is produced

with labor services Ne;t and capital Ke;t�1, using the technology:

Xe;t = "zt (Ke;t�1)� (Ne;t)

1�� (10)

where Ne;t = !sNs;t + (1� !s)Nb;t, 0 < � < 1; and "zt is a productivity shock. The capital

stock evolves according to:

Ke;t = Ie;t

h"Ikt � Sk(Ie;t; Ie;t�1)

i+ (1� �k)Ke;t�1 (11)

where 0 � �k � 1, Sk(Ie;t; It�1) are external adjustment costs de�ned as:

Sk(Ie;t; Ie;t�1) =sk2

�Ie;tIe;t�1

� 1�2

(12)

with sk � 0 and "Ikt is an investment speci�c shock. Borrowing is constrained by:

Le;t � �e�tLe;t�1 + (1� �e) etEt

PXt+1Xe;t+1 �Wt+1Ne;t+1

Re;t� Pt"et

!(13)

where 0 < et = e0"�et < 1; e0 measures the degree of (commercial) loans market tightness

of the domestic economy; "�et captures instead subjective lenders perceptions of the riskiness

of entrepreneurs�assets. Due to perfect competition in the sector, the expected value of the

collateral is equal to the expected return on the capital stock - wages have to be paid for at

least one period after the production process is repossessed by the lender. The parameter

0 � �e � 1 allows for inertia in the adjustment over time of the borrowing constraint.

9

Since both bt < 1 and et < 1;intermediaries expect to be able to obtain only a share

of the expected value of the collateral due to foreclosure costs (see Aoki at al. (2009) for

a similar speci�cation). Hence, new loans to the private sector can not exceed a fraction of

the expected present value of collateral net of default shocks.

2.3 Production and international trade

We assume a vertically integrated production structure with branding, wholesale, and retail

�rms. Branding �rms purchase Xt from entrepreneurs, di¤erentiate it, and sell it to wholesale

�rms at a markup; wholesalers aggregate branded goods into composite goods and sell them

competitively to domestic and foreign retail �rms. Retail �rms combine domestic and foreign

goods to produce �nal non-traded goods for private and public domestic use.

2.3.1 Branding Firms

Monopolistically competitive branding �rms, indexed by l 2 [0; n], purchase Xl;t at price PXt ;

and di¤erentiate it into Yl;t units of intermediate goods, using the linear technology:

Yl;t = Xl;t � F (l) (14)

where F (l) are �xed costs, chosen so that branding �rm�s pro�ts are zero in steady-state.

Following Calvo (1983), we assume that at time t each monopolistically competitive branding

�rm is allowed to revise its price with probability (1� �) � 0. When setting prices, branding

�rms choose eP Yl;t to maximize the market value of the �rm, i.e.:maxXl;t

E0

1Xt=0

�ts�s;t[l;t] (15)

where

l;t = P Yl;tYl;t � PXt Xl;t (16)

subject to the demand for Yl;t. If the �rm cannot re-set its price, it charges last period�s

price multiplied by the steady-state gross in�ation rate �, Pl;t = �Pl;t�1. Therefore, with

probability �q the price �l eP Yl;t will be in e¤ect in period t+ q.Letting epYl;t � ePYl;t

Pt;the real price of branded goods at time t is:

pYt �P YtPt

=

�(1� �)

�epYl;t�1�� + ��(�t)�1�pYt�1�(1��)� 11��

(17)

10

2.3.2 Wholesale �rms

Wholesale �rms, indexed by j 2 [0; n], buy branded goods l at a price P Yl;t, aggregate them

into a composite domestic good using a Dixit-Stiglitz aggregator and sell them to domestic or

foreign retail �rms. The technology to produce composite goods is:

Yj;t = YD;j;t + YM�;j;t =

24� 1n

� 1�

nZo

(Yl;j;t)��1� dl

35 ���1

(18)

where 0 � � � 1 is the elasticity of substitution among brands, and where the notation Yl;j;tmeans brand l, by wholesaler j at time t. Because � is the same for domestic and export

goods, the law of one price holds, see Obstfeld and Rogo¤ (1995).

The demand for Yl;j;t is determined by minimizing the expenditure required to produce a

given amount of composite good Yj;t. The aggregate price for the composite good Yt is:

P Yt =

24 1n

nZo

(P Yl;t)1��dl

35 11��

(19)

2.3.3 Retail Firms

Retail �rms, indexed by i 2 [0; n] ; act in a perfectly competitive market, demand composite

goods, YD;i;t and Y �M;i;t from domestic and foreign wholesalers to produce a �nal non-tradable

good, Zi;t, used for private and public consumption, and for housing and capital investment

with the CES technology:

Zi;t =h(1� !F )

1� (YD;i;t)

��1� + (!F )

1��Y �M;i;t

� ��1�

i ���1

(20)

where 0 � !F < 1 is a share parameter, and � > 0 an elasticity parameter. The demand for

composite domestic and foreign output is determined by the minimization of the expenditure

needed to produce a given amount of �nal good, subject to (20). The price of the �nal good

Pt is given by:

Pt ��(1� !F )

�P Yt�1��

+ !F

�P Y

�t

�1���1=(1��)(21)

2.3.4 International Trade

International trade occurs because retail �rms import composite goods from foreign whole-

salers. The demand for imports is given by

11

Y �M;i;t = !F

�P Y

�t

Pt

���Zit

Similarly, the demand for domestic products by the foreign retailer i� is:

YM�;i�;t = !F �

�P YtP �t

����Z�i�t (22)

where Z�i�;t is the output of the foreign �nal goods producer i�, 0 � !F � < 1 and �� > 0,

are, respectively, the share of imports and the elasticity of substitution abroad and P �t is the

price of the �nal good abroad.

2.4 Production of Houses

Construction �rms, indexed by h 2 [0; n], purchase housing investment goods Ih;t at a price Ptfrom the domestic retailers and transform them into new housing units, �t sold at a nominal

price PHt . House production is subject to adjustment costs.

Since the representative house producing �rm is owned by patient households, it maximizes

the expected discounted value of pro�ts, h;t taking patient household preferences into account

maxfIhtg

E0

1Xt=0

�ts�s;t [h;t] (23)

where:

h;t = PHt �t � PtIh;t (24)

and:

�t � Ht � (1� �h)Ht�1 =�"Iht � Sh (Ih;t; Ih;t�1)

�I l;t (25)

with < 1; where "Iht is an investment speci�c housing shock. The function Sh (Ih;t=Ih;t�1)

represents housing investment adjustment costs and it is given by

Sh (Ih;t; Ih;t�1) =sh2

�Ih;tIh;t�1

� 1�2

(26)

where sh � 0. Since the production technology features decreasing returns to scale, the

speci�cation we use is equivalent to assuming that the production of houses requires a factor

of production, such as land, which is in �xed supply (see Davis and Heathcote, 2005).

12

2.5 Financial Intermediation

The intermediary sector is composed of retail and investment banks. Retail banks lend to

borrowing households and provide funds to the global interbank market. Investment banks

lend to entrepreneurs and to the government. Retail banks obtain funds from depositors;

investment banks borrow funds from the global interbank market.

2.5.1 Retail Banks

Retail banks, indexed by m 2 [0; n], are owned by patient households but run by managers

who discount the future more than their stockholders - managers prefer pro�ts today more

than the patient household as they do not know if they will continue to manage the bank in

the future; for a similar assumption see Rios Rull, Takamura and Terajima (2014).

The problem of the representative retail bank is to choose deposits, Dm;t, loans to domestic

impatient households, Lm;t, and funds to be lent in the interbank market, IBm;t;to maximize

maxfDm;t;IBm;t;Lm;tg

E0

1Xt=0

�tm�s;t [m;t] ; (27)

�m < �s; �s;t is the marginal utility of one unit of dividends for patient households, and

dividends m;t equal net income NIm;t minus the change in bank capital �KBm;t with:

NIm;t =�REAt�1 � 1

�IBm;t�1 + (Rb;t�1 � 1)Lm;t�1 � (Rs;t�1 � 1)Dm;t�1 � PtACm;t (28)

REA is the area-wide policy rate, IBm;t = IBf;m;t + IBf�;m;t; ACm;t = ACs;m;t +ACb;m;t, are

external real adjustment costs of attracting deposits and adjusting loans:

ACs;m;t =as2

�Dm;t=PtDm=P

� 1�2 Dm

P(29)

ACb;m;t =ab2

�Lm;t=PtLm=P

� 1�2 Lm

P(30)

where DmP and Lm

P are the real steady state level of deposits and loans of retail banks

and as � 0; ab � 0. The change in bank capital is given by:

�KBm;t = KB

m;t �KBm;t�1 � Pt"mt (31)

where KBm;t � IBm;t+Lm;t�Dm;t; "mt = (1� �t) "

ft +�trert"

f�

t +(1� !s) "bt are total default

losses su¤ered by retail banks, with rert =P �tPt, and �t = �0"

�t > 0. Retail banks incur default

13

losses because domestic households default or because domestic or foreign investment

banks default. "�t is a shock a¤ecting �nancial integration - �t measures the amount of loans

that investment banks obtain from foreign retail banks, see below.

Equations (28) and (31) imply that bank capital accumulates as:

KBm;t = KB

m;t�1 +

�1� m;t

NIm;t

�NIm;t (32)

where�1� m;t

NIm;t

�NIm;t are retained earnings.

Retail banks face a capital adequacy constraint linking the value of their assets and their

net worth, see also Guerrieri, Iacoviello and Minetti (2012), and Iacoviello (2013):

KBm;t � �m�t

�KBm;t�1

�+ (1� �m)

��IBt IBm;t + �

Lbt Lm;t � Pt"mt

�(33)

where 0 � �m � 1 allows for inertia in the adjustment over time of the capital constraint and

0 � �IBt ; �Lbt � 1 measure the riskiness of various assets in the bank portfolio.

Capital adequacy requirements depend on the risk weight coe¢ cients �IBt and �Lbt . If

�jt = 0 asset j is riskless and the higher is �jt , the riskier that asset is for the purposes of

capital adequacy. We allow the valuation coe¢ cients to re�ect economic conditions:

�Lbt =

��Lb0"�mt + �Lb1

�Lm;t=GDPtLm=GDP

� 1��

(34)

�IBt =

��IB0"�mt + �IB1

�IBm;t=GDPtIBm=GDP

� 1��

(35)

where �Lb0

> 0,�Lb0

> 0; "�mt is a capital requirement shock; and Lm and IBm are the

steady-state equilibrium values for household and interbank loans. Thus, the speci�cation we

use comprises two important features of the Basel III regulatory system: the risk-weighted

assessment of assets, and the cyclicality of capital requirements 1.

2.5.2 Investment Banks

Investment banks, indexed by f 2 [0; n] ; are also owned by patient households. The manager

of the investment banks are also assumed to discount the future more than patient house-1The 2010 Basel III rule requires banks to hold 4.5% of common equity and 6% of Tier I capital of "risk-

weighted assets". The 2011 revision introduces "additional capital bu¤ers": (i) a "mandatory capital conser-

vation bu¤er" of 2.5% and (ii) a "discretionary counter-cyclical bu¤er", which would allow national regulators

to require up to another 2.5% of capital during periods of high credit growth (BIS, 2011).

14

holds, �f < �s. The problem of the representative bank is to choose interbank borrowing,

IBf;t; IB�f;t;lending to domestic entrepreneurs,Lf;t; and investment in a portfolio of govern-

ment bonds BPf;t, to maximize the present value of nominal dividends f;t:

maxfIBf;t;IB�f;t;Lf;t;BPf;tg

E0

1Xt=0

�tf�s;t [f;t] ; (36)

Dividends equals net income NIf;t minus the change in bank capital �KBf;t; where

NIf;t = (Re;t�1 � 1)Lf;t�1+ (Rp;t�1 � 1)BPf;t�1��REAt�1 � 1

� �IBf;t�1 + IB

�f;t�1

�+PtACf;t

(37)

Rp;t is the return on the portfolio,REAt is the central bank nominal rate, ACf;t are real external

costs of adjusting entrepreneurs�loans, given by:

ACf;t =ae2

�Lf;t=PtLf=P

� 1�2 Lf

P(38)

where ae � 0, and Lf are steady state entrepreneurs loans and

�KBf;t = KB

f;t �KBf;t�1 � Pt"et + Pt"

ft (39)

where KBf;t � Lf;t+BPf;t�IBf;t�IB�f;t:Investment bank capital may fall due to commercial

default losses and increase when the investment bank defaults on its interbank obligations.

Given (37) and (39), investment bank capital accumulates at the rate:

KBf;t = KB

f;t�1 +

�1� f;t

NIf;t

�NIf;t (40)

where�1� f;t

NIf;t

�NIf;t are retained earnings.

Investment banks face a constraint on their interbank borrowing: they need to post a

collateral and in case the interbank loan is not repaid, foreign creditors are paid a share

�t < 1 of assets net of default shocks, while domestic creditors get 1 � �t. Knowing this,

foreign (domestic) retail banks constrain interbank loans to domestic investment banks to a

fraction �t (1� �t) of the risk-weighted value of net assets. Thus, the constraints investment

banks face when borrowing from domestic and retail banks are

IBf;t � �f�tIBf;t�1 +�1� �f

�(1� �t)

��Let Lf;t + �

BPt BPf;t � Pt

�"et � "

ft

��IB�f;t � �f�

�t IB

�f;t�1 +

�1� �f

��t

��Let Lf;t + �

BPt BPf;t � Pt

�"et � "

ft

��(41)

15

where 0 � �f � 1 allows for slow adjustment of the constraint and the coe¢ cients 0 <

�Let ; �BPt � 1 determine the risk-weight of investment banks�assets. We assume:

�Let =

��Le0"�ft � �Le1

�Lf;t=GDPtLf=GDP

� 1��

(42)

�BPt =

��BP0"�ft � �BP1

�BPf;t=GDPtBPf=GDP

� 1��

(43)

where "�ft is a valuation shock; and Lf and BPf are the steady-state equilibrium values

of entrepreneur loans and of the bond portfolio. In (42)-(43) we allow investment banks�

valuations to be countercyclical whenever �Le1 and �BP1 are positive.

The portfolio of investment banks includes government bonds of the two countries:

BPf;t =h(!p)

� 1� (Bf;t)

1+�� + (1� !p)�

1��B�f;t

� 1+��

i �1+�

(44)

where � > 0 is the elasticity of substitution between domestic and foreign bonds and 0<

!p <1 determines the holdings of domestic government bonds at t. It follows that the return

on the portfolio of domestic investment banks is:

Rp;t = !pRt + (1� !p)R�t (45)

2.6 The �scal authority

The domestic �scal authority �nances exogenous government purchases, Gt and the interest

payments on its cumulated debt by issuing new debt, Bt; and collecting lump sum taxes, Tt =

Tst + Tb;t from domestic consumers to satisfy:

PtGt +Rt�1Bt�1 = Bt + PtTt; (46)

where GtYt = g"gt , g is the steady-state ratio of government purchases to output and "gt a shock.

Government debt is held by domestic and foreign investment banks:

Bt = Bf;t +Bf�;t: (47)

We assume that lump-sum taxes respond to cyclical conditions and to expand the stock

of debt according to the rule:

ln

�ttt

�= t1 ln

�bt�1b

�+ t2 ln

�YtY

�+ "�t (48)

16

where tt = TtYt; bt =

BtYt; t; b; and Y are the steady-state level of the taxes-to-output ratio,

debt-to-output ratio, and output respectively; "�t is a shock that causes taxes to deviate from

the assumed rule, see Pappa (2009). The parameters 0 � t1; t2 � 1 re�ect di¤erent preferences

for debt deleveraging and output stabilization.

2.7 Monetary Policy

Monetary policy is conducted by a common central bank that targets the area-wide CPI

in�ation, the area-wide output, and an area wide �nancial aggregate using the rule:

ln

�REAtREA

�= ln

" REAt�1REA

!�R ���EAt�EA

� � �Y EAt

Y EA

� Y �finEAtfinEA

� fin�1��R#+ "Rt (49)

where "Rt is a monetary policy shock, 0 � �R � 1; Y ; fin � 0; � > 1, �EA is the (quarterly)

target for gross CPI in�ation, Y EA is the steady state output and finEA is the steady state

aggregate credit to GDP of the non-�nancial sector. The area-wide variables are de�ned as:

�EAt = n�t + (1� n)��t (50)

Y EAt = nYt + (1� n)Y �t (51)

finEAt = n(1� !s)Lb;t + Le;t

PtGDPt+ (1� n)

(1� !�s)L�b;t + L�e;tP �t GDP

�t

(52)

2.8 The resource constraints and market clearing conditions

Since agents of the same type choose identical allocations in equilibrium, the aggregate quan-

tity, expressed in domestic per-capita terms, of any home variable @i;t is:

@t =1

n

nZ0

@i;tdi (53)

The aggregate quantity, expressed in foreign per-capita terms, of any foreign variable @�i�;t is:

@�t =1

1� n

1�nZ0

@�i�;tdi� (54)

Cross-border variables will be expressed either in home or foreign per-capita terms, as conve-

nient. Per-capita domestic GDP is given by

Yt = YD;t +1� nn

YM�;t (55)

17

where YM�;t is measured in foreign per-capita terms. Per-capita domestic demand is:

Zt = Ct + Ie;t + Ih;t +Gt (56)

Letting e;t be entrepreneurs pro�ts, z;t be aggregate pro�ts of branding �rms, i;t be

pro�ts from �nal goods producing �rms, h;t be pro�ts of house producing �rms, m;t be

(non-retained) pro�ts of retail banks, f;t be (non-retained) pro�ts of banks and expressing

IBf�;t and B�f;;t in foreign per-capita terms, the market clearing conditions are:

Ct = !sCs;t + (1� !s)Cb;t (57)

Ht = !sHs;t + (1� !s)Hb;t (58)

Nt = !sNs;t + (1� !s)Nb;t (59)

It = Ie;t + Ih;t (60)

Dm;t = !sDs;t (61)

Lm;t = (1� !s)Lb;t (62)

Lf;t = Le;t (63)

IBt = IBf;t +1� nn

IBf�;t (64)

Bt = Bf;t +Bf�;t (65)

BPt = Bf;t +1� nn

Bf�;t (66)

DIVt = e;t +z;t +i;t +h;t +m;t +f;t + PtACt = !sDIVs;t (67)

Aggregating the economy�s budget constraints and using equation (55) determines the

balance of payments identity:

TBt =1� nn

�B�f;t �R�t�1B�f;t�1 + IBf�;t �REAt�1IBf�;t�1 + �tP �t "f�;t

���Bf� �Rt�1Bf�;t�1 + IB�f;t �REAt�1IB�f;t�1 + �tPt"f;t

�(68)

where the trade balance de�ned as:

TBt �1� nn

P Yt YM�;t � P Y�

t Y �M;t (69)

2.9 Sources of Fluctuations

The model features many sources of traditional demand and supply shocks (productivity,

"z, housing demand, "h , government expenditure, "g, tax shock, �� ;two investment speci�c,

18

"Ik , "Ih ; and monetary policy, �R;disturbances) which can be ampli�ed via the �nancial

constraints in the standard way and will not be considered here. Instead, we focus attention

on three default shocks (one for impatient households, "b, one for entrepreneurs, "e, and one

for investment banks, "f ), on three valuation shocks (one for impatient households, "ib, one

for entrepreneurs, "ie; and one for investment banks, "if ), on the capital requirement shock

"im and the �nancial integration shock "�: The process for these seven shocks is assumed

to be an AR(1) with either common or independent disturbances, see below.

The optimality conditions of the model and the strategy adopted to solve the model are

in appendix A.

2.10 Discussion

A number features of our model economy deserve some discussion. First, the vertically

integrated production structure, which transforms investment goods into �nal good in

various layers, is chosen to separate the pricing problem from the trade and aggregation

problem, see Dib, 2008, Bouakez, Cardia, and Ruge-Murcia, 2009, Resende, Dib and Kichian,

2010, and Dib, Mendicino and Zhang, 2013 for similar setups.

Second, while loans are not a direct argument of the production functions, the

volume of loans is an important determinant of production in our model. Since output

is demand driven and since impatient household and entrepreneurs face binding borrowing

constraints, the volume of banks loans indirectly a¤ects aggregate demand and output.

Third, while the model features default shocks, there is no default, in the sense that

borrowers renege on their obligations in certain states of nature. Banks su¤er �haircuts�

when default shocks occur and take this possibility into account in their lending strategies.

Thus, while the model does not capture a scenario where a series of negative income

shocks make borrowers unable to repay their debt, it can mimic a situation where lenders

are forced to accept less than what is contractually agreed, possibly, to avoid a disorderly

default process. Notice that default shocks enter the collateral constraints since banks

observe default shocks and form expectations. If banks do not foresee these shocks, loans

will be instantaneously contracted only to the extent that default shocks indirectly a¤ect

the value of the collateral through interest rates and prices .

19

Fourth, the model features an interbank market between (lending) retail banks and

(borrowing) investment banks. This market exists not because di¤erent types of banks

have di¤erent investment opportunities (see e.g. Zhang, 2014) , there are maturity mismatch

between assets and liabilities, or liquidity issues in the balance sheet of banks, but because

the lending market is segmented - di¤erent banks specialize in di¤erent types of loans.

Notice that the interbank market resembles a repo market: at the beginning of each

period retail banks lend part of the deposits to investment banks and they receive

collateral assets that the investment banks purchase with the funds (Government bonds

or entrepreneurs loans). Thus, investment banks in the model behave like real world

shadow banks: they do not collect deposits but purchase funds from other banks and then

lend to the private sector. Note that the interbank market is global, competitive, clears

at the area wide interest rate and never shuts down: shocks a¤ect the amount of funds

intermediated, but they will never cause the market to stop functioning.

Fifth, the capital adequacy constraint on retail banks is equivalent to a borrowing

constraint. In fact, using the de�nition of bank capital, the capital constraint can be

equivalently written as a constraint on deposits:

Dm;t � �m�tDm;t�1 + (IBm;t + Lm;t)� (1� �m)��IBt IBm;t + �

Lbt Lm;t � Pt"m;t

���m�t (IBm;t�1 + Lm;t�1) (70)

The model features two types of domestic �nancial-real linkages: one endogenous

and one exogenous. The endogenous mechanism is due to the fact that traditional

demand and supply shocks a¤ect the �nancial constraints by changing the value of the

collateral pledged by borrowers - this is the standard �nancial accelerator mechanism of

Bernanke, Gertler and Gilchrist (1999). For example, a contractionary monetary policy

shock, increases in the nominal interest rate and makes production fall. However, since it

reduces the value of the collateral, the amount of loans to the private sector falls, and

this further contracts economic activity amplifying the initial e¤ect the shock.

Exogenous sources of linkages instead come from �nancial shocks. Default and valuation

disturbances alter the willingness of banks to grant loans, for a given value of the

collateral they receive. These shocks may have real consequences because, when the

assets of the banking sector decrease, it becomes more di¢ cult to produce or buy

20

houses - the �nancial frictions becomes tighter - and since aggregate demand contracts,

the real economy shrinks as well. Capital requirement shocks, on the other hand, change

the supply of loans for a given value of bank assets. Finally, integration shocks change the

composition of interbank loans, alter the amount of loans entrepreneurs of both countries

receive and thus a¤ect demand and production. Because the �nancial shocks we consider

redistribute wealth either between lenders and borrowers or across countries, they may

a¤ect the composition of demand and produce additional real adjustments.

Since the two economies are open, one should expect �nancial shocks to generate

international repercussions. Given that our economy features both trade and �nancial �ows,

idiosyncratic domestic disturbances may be transmitted via demand for goods and via

interbank transactions. One interesting question is which channel is more important and

whether foreign quantities or prices respond most to the disturbances.

3 Parameter selection

The parameter values used in the exercises are in table 1. Most of the values are standard,

see e.g. the capital depreciation rates, the risk aversion coe¢ cient, the external habit

parameter, the adjustment cost parameters, etc.. Some of the parameters are selected to

give realistic starting values for the dynamic exercises: thus, for example, we chose the

steady state government debt to output ratio to be 0.9, the size of the periphery to

be 0.2, and the steady state nominal interest rate to be 2 per cent. Parameters speci�c

to the class of models featuring patient and impatient households are set in line with

what the previous literature has used (see e.g. Lambertini, Mendicino and Punzi, 2013)

or estimated (see e.g. Iacoviello and Neri, 2010). The parameters regulating the �nancial

constraints of di¤erent agents are selected using two criteria: the speed of adjustment

is chosen to produce duration of responses that match what other work has assumed

(see In�t Veld et al., 2011, or Kollman, Enders and Mueller, 2011); the valuation parameters

re�ect perceptions of the relatively riskiness of various assets. Since several �nancial

parameters are not pinned down by these two criteria, we use our judgment to select

them and present sensitivity analysis to robustify the conclusions. Finally, the parameters

of the law of motion of the shocks, the adjustment costs parameters for deposits and

21

loans, and the price stickiness parameter are selected to obtain particular response path of

certain variables - see the next section for details.

To make sure that the model produces a realistic setup, we have computed the

steady states of the endogenous variables. A sample of the value obtained for the domestic

variables is in Table 2. On average, the domestic consumption is about 79 percent, investment

in equipment is about 10 percent, loans are about 66 percent and imports are about 50 percent

of output. In comparison, in the periphery of the Euro area (Portugal, Ireland, Italy, Spain

and Cyprus) over the period 1980-2013, the average consumption to output ratio is between

70 and 84 percent; the (total) investment to output ratio is between 9 and 17 percent; the

loans to GDP ratio is between 0.62 and 0.80 percent; the average import to GDP ratio is

between 25 and 51 per cent. The capital-output ratio is close to the average capital-output

ratio in the Euro area (4.5). Patient households own, on average, almost twice as much

housing as impatient households - housing is an investment good for patient households.

In the model, corporate loans are about half of mortgage loans as a percentage of GDP. In

the data this ratio varies a lot: in Portugal, Spain and Ireland it is between 50 and 80

percent; in Italy about 130 percent. Since deposits are roughly as large as output in the

steady states, the steady state loans to deposits ratio is two-thirds, which is close to the

average in the Euro area periphery in the 1980s but considerably below the value in the

2000�s - in this period, the ratio is 0.9 in Portugal and 1.4 in Italy.

To check that our calibration also produces reasonable cyclical �uctuations, we set

the persistence of all autoregressive shocks to 0.9 and all the standard deviations to 1.0 and

compute second moments of the endogenous variables. Table 3 present the results when the

economy is simultaneously hit by the three default shocks ("b, "e,"f ), the three valuation

shocks ("ib, "ie , "if ), the capital requirement shock "im, the �nancial integration shock "�;

the productivity "z shocks and the �ve demand shocks ("h , "g, "Ik , "Ih ; �m).

In the model, consumption and house holdings have low relative standard deviations,

while investments, mortgage and commercial loans �uctuate more than output. In the

cross section of peripheral Euro area countries, house holdings is less volatile than output

(around 0.5), consumption is roughly as volatile as output (the range is 0.8-1.1), investment

is more volatile than output (the range 4.0- 11.5) as are mortgage and commercial loans

22

(range 1.8-4.9). Two features of the model �uctuations are somewhat inconsistent with

the data: in�ation is less volatile than output in the model, but roughly as volatile as

output in the data (range 0.8-1.3); hours are less volatile than output in the model;

in the data, this relative volatility varies (range 0.65,- 1.8). Reporting and to measurement

errors may account for the di¤erences.

Hours and in�ation are the variables with the lowest persistence, followed by investment

and output; all other variables have a �rst order autoregressive coe¢ cient of at least 0.9.

Notice that house holdings of patient and impatient households have di¤erent persistences,

because the latter type of households face a borrowing constraint. In the cross section of

peripheral Euro area countries we �nd that hours is indeed not very persistent (range

0.1-0.6) but that in�ation is somewhat more persistent than in the model (range 0.75-0.85).

The persistence of investment and output are country speci�c and range from 0.5-0.8.

Finally, in accordance with the predictions of the model, the persistence of �nancial

variables and house prices is high and generally larger than 0.9.

The model also predicts that domestic output is positively correlated with the amount

of housing held by patient households, with lending to the entrepreneurs, and with in�ation.

In turn, (CPI) in�ation is positively correlated with the amount of housing held by patient

households. The nominal interest rate is also positively correlated with the amount of housing

held by both households, with output and in�ation. Finally, lending to entrepreneurs is

positively correlated with lending to the households. These patterns are also found in

peripheral Euro area countries.

4 Dynamic analysis

In this section we describe the dynamics induced by �nancial disturbances, examine

di¤erences that shocks to di¤erent sectors produce, and provide some evidence on how

crucial parameters a¤ect the responses of key macroeconomic variables.

4.1 Default shocks

The dynamics induced by the three default shocks in �gures 1-4. Recall that a household

default shock unexpectedly transfers resources from the retail bank sector (and thus from

23

the patient households who own them) to impatient households; an entrepreneur default

shock transfers resources from the investment bank sector to the entrepreneur sector, both

of which are owned by patient households; and a investment bank default shock

redistribute resources within the banking sector. Household (entrepreneur) default shocks

are calibrated to produce a large and persistent fall in domestic household (commercial)

loans to GDP ratio - 10 percent from the steady state after one year and around 5

percent of the steady state value up to 5 years. The investment bank default shock is

instead calibrated so that, on impact, retail bank capital falls by 5 percent from the

steady state value - its dynamic path is left unrestricted.

Default shocks are globally recessionary: they contract aggregate demand, production

and in�ation in both countries; a signi�cant reduction in the intermediation activities of

banks; and a decline in house prices and house constructions. Moreover, the central

bank interest rate persistently declines. Default shocks a¤ect the pro�ts of the banking

sector, which responds by contracting loans. Since pro�ts fall, patient households income

also falls. Thus, to limit the reduction in the current level of consumption and housing,

they reduce deposits, leading to a contraction of the domestic intermediation activities.

As mentioned, with household default shock, there is a redistribution of wealth from

patient and impatient households which is absent when the default shock occurs in the

other two sectors. However, the unexpected income windfall is more than compensated

by the increase in the borrowing rate and by the fall in the value of their housing assets.

Thus, in all cases, impatient households demand falls. Since the demand for goods by

both types of households fall, and since investment demand also falls, aggregate demand

declines. Output, which is demand determined, falls as well, leading to a fall in hours

worked and real wages. Furthermore, since the marginal cost of production falls, in�ation

declines as well. The policy rate then fall because both area wide output and area

wide in�ation fall and the decrease is more pronounced with bank default shocks.

International transmission occurs via trade and the interbank market. With household

default shocks, domestic retail banks have extra funds (deposits fall less than household

loans) and they channel them to the interbank market. However, foreign investment

banks do not take immediate advantage of the increase volume of interbank transactions

24

because the fall in domestic imports induces a fall in foreign production of intermediate

goods. This leads to a reduction in the loans demanded by foreign entrepreneurs, in

foreign aggregate demand, and output. With the other two default shocks the volume of

transactions in the interbank markets falls. Thus, foreign investment banks contract loans

to foreign entrepreneurs. This contraction further reduces foreign aggregate demand, leading

to lower output and in�ation. In response to default shocks domestic and foreign real

asset rates increase on impact. The exception are foreign rates when household default

shocks occur since the volume of transactions in the interbank market increases.

Four additional features of the simulations are worth discussing. First, while default

shocks induce persistent adjustments in �nancial variables, they produce short lived

recessions and only consumption is persistently a¤ected. Real adjustments are short lived

because the �nancial accelerator is relatively weak. In fact, the price of assets used as

collateral do not respond strongly and persistently to the shocks.

Second, the magnitude of the adjustments in the real exchange rate (RER) is small.

Responses are negligible because the RER is determined by technological conditions which

are una¤ected by the shocks. Intuitively, the aggregate demand in the two countries

moves in the same way. Thus, the prices of domestic and foreign consumption, which

move one to one with the price of aggregate demand, are similarly a¤ected.

Third, in response to household default shocks, domestic investment and import

increase after a few periods. This occurs because our simulations produce a small medium

term increase in foreign output, which is accompanied by an increase in foreign hours

worked, foreign investment and foreign demand for domestically produced goods which is

accommodated by increasing domestic investments and production. Thus, after an initial

contraction, an export led recovery materializes in the domestic economy.

Fourth, the dynamics of loans and deposits deserves some attention. All domestic

default shocks imply a substantial and persistent contraction of lending activities abroad

making the credit crunch global. The dynamics of deposits are instead shock speci�c: they

instantaneously decline with household and entrepreneurs default disturbances, because

the income of patient households is negatively a¤ected. They instead increase, both

domestically and abroad, after bank default shocks because the volume transacted in the

25

interbank market falls substantially. Thus, foreign banks adjust their balance sheet by

o¤ering higher rates on deposits. Because the return on comparable assets move together,

the domestic deposit rate also increases, leading patient households to save more.

Default shocks produce important sectorial changes. Consumption of both types

of households in both countries falls and household default shocks produce the most

persistent consumption responses because patient households � income is more strongly

a¤ected. However, the dynamics house holdings of patient and impatient households

di¤er. Recall that impatient households are on a corner solution. Thus, whenever the

constraint is relaxed, as in the case of household default shocks, they will buy more

houses. The housing demand by patient households instead depends on their income.

Thus, when income falls, their demand for houses also falls.

4.2 Private valuation shocks

We calibrate valuation shocks to generate a 10 percent decline in household (commercial)

loans to GDP ratios from its steady state after one year and to remain persistently below

the steady state by 5 percent up to �ve years. Since we interpret valuation shocks as

re�ecting lenders�perceptions about the value of the collateral, we report simulations when

household and entrepreneurs valuation shocks are perfectly correlated and name them in

�gures 5�8 �risk perception�shocks.

Risk perception shocks also produce a global recession, a fall in aggregate demand,

hours worked and real wages, both in the domestic and in the foreign economy; a

signi�cant decline in house prices and house demand, a fall in the area wide in�ation

and in the central bank policy rate.

The adjustments produced by risk perception shocks are similar to those induced by

impatient households and entrepreneurs�default shocks. Since these disturbances alter

the perceived value of the collateral posted by borrowers, domestic loans will be reduced.

The contraction of credit makes entrepreneurs and banks pro�t decline. Hence patient

households have less pro�t income and shift resources away from deposits and housing in

order to smooth the e¤ects of the disturbances on consumption. Impatient households,

who face a credit crunch, �nd themselves with lower income. Thus, domestic aggregate

26

demand output, hours worked, real wage and in�ation all fall.

The international transmission occurs, also in this case, via goods and interbank

markets: since the volume of the interbank market increases, more funds are available to

foreign banks. However, since domestic imports fall a lot, foreign production instantaneous

contracts. With a lag foreign commercial loans and foreign deposits increase - the latter

following an increase in the deposit rate - and the increase in credit produces a positive

a small expansion in foreign activity which increases foreign demand for domestic goods

and thus domestic investment and output. Hence, the model predicts that risk perception

shocks will also generate a medium term export-led domestic recovery. The recovery will

be weaker because the contraction of domestic credit is smaller.

The positive foreign e¤ects are driven by the fact that �nancial resources are shifted

from the domestic to the foreign economy, as retail banks alter the composition of their

portfolio of loans. A shift of �nancial resources from the periphery and to the core of

the Euro area did occur during the recent credit crunch, but a global credit crunch also

impaired the functioning of the interbank market. Because the interbank market can not

be exogenously shut down in the model, we can only conjecture that the foreign expansion

will be made weaker in this situation. Note that there are two reasons for why, after

the initial fall, domestic investments quickly recover. On one hand, global demand channel

produces an export-led increase. On the other, the return to domestic capital declines on

impact but then immediately increases and converges to the steady state from above.

This capital e¤ect reinforces the export-led demand push on domestic investments.

With risk perception shocks domestic and foreign asset rates have di¤erent adjustments:

domestic rates all increase, while foreign rates all fall, at least instantaneously, as �nancial

resources move to the foreign economy. The central bank real rate instantaneously falls,

as both area wide output and in�ation fall, and persistently stays below the steady state

because of the persistent fall in area wide in�ation.

Risk perception shocks redistribute resources across domestic households. Consumption

of both patient and impatient households falls, both at home and abroad, since the income

of both types of households contracts. However, while patient households reduce their

holdings of houses and their hours worked, borrowers increase their holdings of houses and

27

their labor supply. The di¤erence is due to the fact that both the deposit and the loan

rate increase. Thus, patient households increase their deposits and their leisure. Impatient

household which are constrained in equilibrium, smooth utility variations by increasing

their labor supply and buying housing, which has both a �ow and a stock value.

4.3 Capital requirement shocks

Valuation shocks may also a¤ect the banking sector. Given the equivalence between a

borrowing and a capital requirement constraint, we chose to make banks valuation shocks

perfectly correlated and call them capital requirement shocks. To mimic a real world scenario,

we calibrated them so that, in both cases, the retail bank capital increases by 5 percent

instantaneously and by about 30 percent after �ve years.

Since capital requirement shocks tighten �nancial constraints, one should expect them

to produce dynamics which are similar to those produced by risk perception shocks: risk

perception shocks negatively a¤ect the value of the collateral; capital requirement shocks

a¤ect the willingness of banks to lend, given a level of riskiness of collateralized assets.

Indeed, the responses in �gures 5-8 con�rm this intuition. A domestic capital requirement

shock generates a global recession, a fall of aggregate demand, in�ation, hours worked and

real wages in both countries and, in agreement with the evidence Wieladek (2014) has

collected in the UK, a contraction in private sector credit. The recession, as with the

other �nancial shocks, is relatively short lived. Relatively speaking domestic credit and

real wages fall less than with risk perception shocks, but the e¤ects on output, investment,

imports, exports, hours worked, lending and policy rates are larger, at least on impact

because the cost of production is larger along the adjustment path following capital

requirement shocks - real wages fall less and borrowing costs are higher. Thus, hire less

labor making the fall in aggregate demand larger.

After the initial negative impact, the foreign country experiences a small expansion

and, as with risk perception shocks, the domestic economy recovers because foreign demand

for domestically produced goods increases. Relatively speaking the expansionary e¤ect

are smaller than with risk perception shocks.

One variable reacts di¤erently from the case of risk perception shocks and thus may

28

allow us to empirically distinguish the two types of shocks. Since banks do not

raise new equities, capital requirement shocks have to be accommodated by changing the

assets or the liabilities side of banks� balance sheet. Figures 5-8 suggests that to obtain

more funds, retail bank increase the domestic deposit rate and patient households respond

by increasing deposits, rather than decreasing them as with risk perception shocks. The

increase in expected future wealth makes patient households better o¤ and the fall in the

consumption along the adjustment path is smaller than with risk perception shocks.

Since domestic retail banks lend less to the private sector and have more deposits,

volume of interbank transaction increases. However, because foreign loan rates increase

and the demand for foreign goods fall, foreign credit and output decrease.

The dynamics of house holdings by di¤erent types of consumers changes relative to

risk perception shocks. Since the deposit rate increases, patient household temporarily

increase their holdings of houses. Impatient households have to bear higher borrowing

costs. This negative wealth e¤ect makes them persistently cut their house holdings.

4.3.1 Sensitivity to parameters

One should expect the magnitude of the �nancial �uctuations and of the real transmission

to depend on some structural parameters we have judgementally chosen. In this subsection,

we examine how the dynamics of domestic mortgage and commercial loans, output, consump-

tion, investment, export and in�ation in response to the shocks change when i) we increase

the size of the domestic country (n moves from 0.2 to 0.4); ii) we decrease the level of �nancial

integration (� moves from 0.35 to 0.05); iii) we lower asset valuation in the LTV constraints

by half ( b0 moves from 0.7 to 0.35 and e0 from 0.37 to 0.175); iv) we decrease the speed of

adjustment in the LTV and capital constraints by half (�m goes from 0.9 to 0.45; �f from 0.75

to 0.375; �B from 0.75 to 0.375, �e from 0.6 to 0.3); v) we make capital requirements for retail

banks 50 percent tighter (�L0 goes from 0.1 to 0.015 and �IB0 from 0.01 to 0.015) and the LTV

constraint of investment banks 50 percent looser (decreasing �e0 from 0.5 to 0.25) - the latter

implies a 50 percent increase in the capital requirement of investment banks; vi) we change

the share of borrowing households (1�! goes from 0.3 to 0.5); vii) the decrease the import

share (!F goes from 0.5 to 0.3). Intuitively, the size of the country and the level of

29

�nancial integration could a¤ect the transmission across countries and the cross country

distribution of the costs. Changes in the parameters regulating the �nancial frictions may

a¤ect the magnitude and, to some extent, the persistence of the real responses. Changes

in the speed of adjustment, on the other hand, may alter the time pro�le of default

costs. Finally, the size and the connection of the two economies may also matter. When

the domestic economy is larger or more connected, output, exports and in�ation should

fall much less, while risk sharing opportunities and consumption could be more a¤ected.

Figures B1-B8 in the appendix report the original responses and the responses obtained

with the new parameter values. Overall, the responses our simulations produce are robust and

changing, for example, the LTV parameters for households and entrepreneurs or the capital

requirements of banks have minor real e¤ects with default shocks. The sign of the responses

changes at times with bank default shocks: mortgage loans, consumption and investments

increase when the domestic economy is larger; mortgages and commercial loans and in�ation

increase when the speed of adjustment is low. The change in sign is due to the fact that

the foreign economy is more negatively a¤ected by the shocks when the domestic economy

is larger. On the other hand, faster deleveraging implies larger negative real changes but

smaller e¤ects on the balance sheet of the intermediaries. Finally, changes in the persistence

of the LTV constraints of households and entrepreneurs, on the other hand, have negligible

e¤ects on the dynamics of real variables and in�ation.

The magnitude of responses to risk perception shocks is also very robust and only

consumption is a¤ected. This occurs, for example, when the size of the country and

the level of �nancial integration change because the amount of international risk sharing

available to households changes and domestic consumption is less negatively a¤ected by the

shocks when the size of the country and �nancial integration are higher.

The speed of deleveraging seems matter for the responses to risk perception shocks:

faster deleveraging of retail banks produces a bene�cial e¤ect on domestic consumption,

investments and output; faster deleveraging for households and entrepreneurs makes

domestic consumption, investments and output decrease more. The reason is that in

the latter case the volume of intermediation of the economy is negatively a¤ected and

lower domestic loans lead to lower domestic output, consumption and investments.

30

The dynamics following capital requirement shocks are more a¤ected by the choice of

parameters regulating �nancial frictions. For example, a lower LTV for households and

entrepreneurs makes the economy contract less in response to the capital requirement

shock and, with higher capital requirement parameters, capital requirements shocks induce

larger �nancial cycles and deeper recessions. A faster speed of deleveraging, on the

other, does not a¤ect output or in�ation; but mortgage and commercial loans fall more

instantaneously. Finally, the faster is the deleveraging speed in the banking sector, the

more negative are the dynamics of consumption in response to capital requirement shocks.

The share of borrowing households has little in�uence on the shape and the persistence

of the responses to the �ve shocks. The only variables a¤ected are aggregate consumption ,

which falls more on impact with household default, risk perception and capital requirement

shocks; and commercial loans, which fall more on impact with household default and capital

requirement shocks. When the share of borrowing households is larger the e¤ects of household

default and capital requirement shocks on total loans and bank pro�ts are larger and this

penalizes lending households, which have to share larger losses over a reduced number of

units. With risk perception shocks total loans are hardly a¤ected but output falls slightly

more on impact, making aggregate consumption fall more.

The import share, on the other hand, a¤ects the magnitude but not the direction

of the adjustments of loans in response to the shocks and, for most disturbances, the

lower the import share is, the larger is the e¤ect. Real variables are a¤ected but it is

primarily the magnitude of the consumption responses which is altered because a lower

import share makes the economy more autharkic.

4.4 What happens to the current account and to government debt?

All the shocks we have considered induce considerable �nancial market volatility and im-

portant adjustments in real variables. One may guess that these disturbances also have

implications for the external position of the domestic country and that they may alter the

ability of the governments to �nance their debt.

Indeed, all shocks instantaneously worsen the external position of the domestic country -

the current account to GDP ratio falls, and in some cases by quite a lot. However, the medium

31

term consequences for the external position depend on the type of shock and the sector

where the disturbance occurs. For instance, household and entrepreneur default shocks lead

to medium term current account surpluses; with bank default or capital requirements shocks

the adjustments are insu¢ cient to close the current account gap.

All disturbances increase domestic government debt, both instantaneously and in the

medium run, as the cost of �nancing greatly increases. The yield on government bonds

increases because there are arbitrage conditions among di¤erent assets that must hold

in equilibrium. Thus, the dynamics of government yields must follow the dynamics of

domestic loans rates, regardless of who holds government bonds in the model. The foreign

government is also negatively a¤ected, as the cost of �nancing increases with four of the �ve

shocks - the model does not feature �safe-heavens� e¤ects that could counteract the

increase in foreign bond yields. Thus, while all �nancial disturbances widen sovereign spreads,

impatient household default shocks can generate both large spreads and large imbalances in

the government debt position, which may require strong public deleveraging, either through

a stronger feedbacks from government debt to taxes or through exogenous changes in the �scal

rule, to make the debt sustainable. In both cases, second round adjustments may make the

real consequences of �nancial shocks more severe.

Because in the baseline scenario, taxes respond to debt to GDP ratio with a small

elasticity (t1 = 0:01), we have also studied what happens if the �scal authority is more

aggressive in bringing the debt to GDP back to its steady state (t1 = 0.15). Qualitatively

speaking, the di¤erences with the baseline simulations are small. Quantitatively, the e¤ects

are larger on impact since higher taxes means lower output.

4.5 Summary

Our simulations show that all �nancial shocks can produce a deep output recession, a

signi�cant contraction of private demand, drops in house prices and housing demand, a large

fall in in�ation, and a considerable reduction of the amount of intermediation activities of

domestic banks. Gilchrist, Yankov and Zakrasjek (2009) showed that these dynamics

occurred in the US in response to what they call �credit spread� disturbance - a shock

which makes the banking sector less willing to lend because its balance sheet situation

32

deteriorates. However, the model does produce enough persistence in real adjustments:

the dynamics of the price of capital, which weaken the �nancial accelerator mechanism,

and the international redistribution of resources which lead to an export-led recovery with

some shocks, drive the result. Financial shocks spread internationally generating global

recessions and both the goods and the interbank markets are responsible for transmitting

the shocks to the foreign economy. All shocks also lead to deterioration of the external

position of the domestic economy, of domestic government �nances and spreads.

Household default, risk perception and capital requirement shocks have domestic distrib-

utional e¤ects because the alter the relative income of patient and impatient households.

Furthermore, these shocks also lead to an international redistribution of resources. In

general, the goods and the interbank markets are responsible for the international

transmission and both prices and quantities adjust to absorb the shocks.

The qualitative features of the transmission that �nancial shocks generate are robust.

Quantitatively, the value of parameters regulating the �nancial frictions, the size of the

economy and the �nancial integration, the import share and the share of borrowing

households have some important repercussions only with capital requirement shocks.

5 Prudential policies

The �nancial shocks we consider produce persistent adjustments in �nancial markets and

important e¤ects on production, demand and in�ation. Furthermore, they force households to

adjust their house holdings and, in the case of patient households, their deposits holdings with

important contractionary e¤ects on house prices and the volume of banking intermediation.

In this section we examine to what extent prudential policies alter the dynamics in response

to shocks. We are interested in whether they can help to dampen �nancial �uctuations and

reduce their persistence (see Lambertini et. al, 2013); and whether they can shield real

variables from the negative e¤ects of �nancial shocks. The model features a number of

prudential tools: we focus on two which have received attention in the literature.

The �rst policy we consider is a direct targeting of credit aggregates in the monetary rule.

Such a policy has been advocated, for example by Borio (2003), as a tool to lean against

credit and house price bubbles; see also Repullo and Saurina (2011) and Gersbach and

33

Rochet (2013). Credit may enter the monetary rule when the monetary authority wishes

to minimize the variability of output, of in�ation, and of credit to GDP ratio. Figure

28 presents the dynamics of a selected number of �nancial and macroeconomic variables

in response to the �ve shocks when the central bank (i) only targets output and in�ation

�uctuations; and (ii) when the aggregate credit to GDP ratio in deviation from its steady

state value enters the rule with the coe¢ cient fin = 0:5:

The second policy we consider is a countercyclical capital requirement on banks

(see Galati and Moessner, 2011). As discussed in section 3, the coe¢ cients regulating the

capital adequacy requirement and the borrowing constraints of banks may depend on cyclical

conditions. The policy we consider takes into account that excessive credit expansion may

lead to higher risks. Thus, in equations(34)-(42)- we set �Le1 = 1 and �Lb1 = 2 so that a

one percent expansion in the loans to GDP from its steady state leads to a 100 (or 200)

basis point increase in the riskiness valuation of private loans. Figures 29 and 30 report

the dynamics of selected real and �nancial variables induced by the �ve shocks in the

baseline scenario and when either �Le1 or �Lb1 are di¤erent from zero.

Targeting credit aggregates matters for �nancial volatility in the case of entrepreneurs

default shocks and of risk perception shocks. Since, the fall in private loans is somewhat

reduced. Also, while the magnitude of the instantaneous output fall is broadly unchanged,

the length of the recession is reduced by half and this makes consumption responses fall

by much less than in the baseline case. The output loss is uniformly smaller than in

the baseline case because domestic investments and exports quickly pick up after the

initial fall. In turn, the superior performance of investments is due to the fact that

the nominal interest rate falls substantially more than in the baseline scenario. Notice

also that with these two shocks in�ation persistently declines up to 10 years. Thus, our

model predicts that de�ation dynamics may prevail when entrepreneurs default and risk

perception shocks hit the domestic economy and the central bank aggressively adjusts the

policy rate to the credit to GDP ratio. With the other shocks, targeting credit aggregates

has minor e¤ects on both output and in�ation, some smoothing e¤ect on commercial

loans and, depending on the shocks, either favorable or unfavorable e¤ects on domestic

consumption. Hence, the stabilizing properties of the policy crucially depend on the type

34

of shock driving the dynamics of the credit to GDP ratio away from its steady state.

Absent such an information, targeting credit aggregates may help to stabilize the

�nancial cycle, but may not reduce the negative real consequences of �nancial shocks.

Prudential capital bu¤ers have relatively limited stabilization e¤ects. For example,

capital bu¤ers on retail banks reduce somewhat �nancial �uctuations but, quantitatively

speaking, the e¤ect is small. As a consequence, the deepness and the persistence of the

output recession, and the dynamics of in�ation are almost unchanged, except perhaps

in the case of risk perception shocks. Cyclical capital bu¤er policies are bene�cial in this

case because the negative consequences these disturbances have on the risk valuation

coe¢ cients are reduced making the initial negative response of investments and exports

smaller. However, because redistribution e¤ects are magni�ed, the negative response of

aggregate consumption becomes larger.

Cyclical requirements on investment banks help to attenuate the �nancial cycle and

the output recession in the case of entrepreneur default shocks and of risk perception

shocks because domestic investments and exports fall less. Thus, the adjustment path of

consumption is above the one obtained when no policy is implemented and, instanta-

neously, in�ation falls less than in the baseline scenario. However, the policy leaves the

dynamics of real variables and in�ation unchanged with the other shocks.

6 Welfare analysis

The �nancial shocks we consider do not only have aggregate real consequences; they

generally produce a redistribution of wealth between households either within one or

across countries and this redistribution may have important welfare implications. In this

section we ask (i) which shock induces the largest (smallest) welfare losses and which type

of household or which country is most a¤ected; (ii) whether prudential policies help to

contain welfare losses; and, if this is the case, which policy is preferable.

We calculate the welfare e¤ects of shocks as follows. For each type of household we

compute the conditional expectation of lifetime utility:

Vjt � maxEt

" 1Xt=0

�tjU(Cj;t;Hj;t; Nj;tj"t)#

(71)

35

where Vjt = fVst; Vbtg is the welfare of patient and impatient households and "t is a generic

shock. Welfare for each country is:

Welft � [!sVst + (1� !s)Vbt] ; (72)

where !s is the share of savers. Global welfare is:

Welfgt � [nWelft + (1� n)Welf�t ] ; (73)

where n is the size of the domestic economy. Table 4 presents the welfare measures we

construct, conditional on each of the �ve shocks. In the �rst panel we report the welfare

level in the baseline case with no prudential policies; in the second and the third panels

welfare changes when the monetary authority targets credit aggregates or when cyclical

capital bu¤ers are imposed on both retail and investment banks.

Household default shocks produce the worst and bank default shocks the best global

welfare outcomes. However, the distribution of welfare losses is not homogenous across

countries: for the domestic economy, losses are minimized with household default shocks;

for the foreign economy losses are minimal with bank default shocks. This happens because

a large portion of the credit contraction costs are passed to the foreign economy with the

�rst disturbance but not with the second. In particular, domestic household default

shocks a¤ect foreign savers a lot; domestic bank default shocks leave them less a¤ected.

Welfare losses for borrowers are similar across shocks: the worst possible outcome

obtains with capital requirement shocks since borrowers of both countries experiences falls

in consumption and housing and increases in hours worked. Overall, household default,

bank default, and capital requirement shocks produce redistribution of wealth either

between savers across countries or between borrowers and savers within a country, and

the losses they produce are large compared to other shocks.

Prudential policies generally improve global welfare. This always true for cyclical

capital requirement; for targeting credit aggregates it is true, except with bank default

shocks. Welfare falls in this case because foreign savers losses are large compared with

bene�ts the policy produces. Quantitatively speaking, the gains obtained targeting credit

aggregates are larger than those obtained with cyclical capital requirement because both

countries bene�t. Within a country, savers are better o¤ when the fall in the central bank

36

rate is large, while borrowers losses are more insensitive to the fall in the central bank

rate. An exception is with household default shocks: here targeting credit aggregates

redistributes resources across countries, making domestic agents worse o¤.

While targeting monetary aggregates produce a redistribution of wealth between

borrowers and lenders in each country, capital requirement policies produce a redistribution

of wealth across countries bene�ting the foreign economy for all shocks - welfare of both

foreign lenders and borrowers improves. Capital requirements reduce the transmission of

shocks via the interbank market, limit the foreign costs and force the domestic economy

to bear the adjustment costs. An exception occurs with household default shocks: here

cyclical capital requirement shocks make domestic savers much worse o¤, while domestic

borrowers, foreign savers and foreign borrowers welfare improves.

Overall, while no policy alters allocations in such a way to improve utility of all agents

in both countries, targeting monetary aggregates lead to the largest global gains. Thus, if

the policy is employed in conjunction with say, redistributive �scal policies, improvements

for all agents could be achieved. Our analysis shows that prudential policies have important

political economy implications: while foreign households always prefer capital requirements

relative to inaction, domestic households are generally worse o¤ with such a policy.

Similarly, the gains from prudential policies are not distributed between patient and

impatient households. In general, the share of borrowing households and the size of the

country experiencing the shocks are going to be important to determine whether area

wide prudential policies will receive popular support or not.

7 Conclusions and extensions

We use a two-country dynamic model with international trade and international �nancial

�ows, to examine how shocks a¤ecting the borrowing and lending capabilities of agents are

transmitted within and across countries. We also study how relevant parameters a¤ect the

propagating of these shocks and evaluate whether prudential policies reduce the magnitude

and the persistence of the �nancial cycle, limit the real consequences, and improve welfare.

We �nd that all �nancial shocks produce a deep output recession; a signi�cant contraction

of private demand; drops in house prices and housing demand; a signi�cant and persistent fall

37

in in�ation; and a considerable reduction of the intermediation activities. Furthermore, the

e¤ects these shocks produce are global. Some shocks redistribute resources between borrowers

and lenders; others redistribute resources across countries and, after a few periods, they

lead to an export-led domestic recovery. The sector where the disturbances occur does not

matter because all shocks contract the lending market.

All the shocks are transmitted, domestically, via loans and deposits markets and, inter-

nationally, via trade and the interbank market. Furthermore, all shocks worsen the external

position of the domestic country, at least in short run, and make domestic government debt

expand, as the cost of �nancing greatly increases. Because sovereign spreads also increase,

these shocks have important implications for the management of public debt.

The qualitative features of the transmission are generally robust. The parameters regu-

lating �nancial constraints a¤ect the dynamics of �nancial and real cycles di¤erently, but the

e¤ects on real �uctuations are small in the case of private sector default shocks and risk

perception shocks. For disturbances originating in the banking sector, the e¤ects of changing

crucial parameters are larger. The direction of real changes depends on the type of shock

and, to some extent, the branch of the banking sector where the shock originates.

Prudential actions by the monetary authority are as good as countercyclical capital bu¤ers

in smoothing out the �nancial cycle and in reducing the real e¤ects of the �nancial shocks.

However, to understand the consequences that prudential policies have, it is important to

know the type of the shock hitting the economy and the sector in which the shock occurs.

Prudential policies generally produce a redistribution of the losses across agents within

a country or across countries and may lead to interesting political economy trade-

o¤s. Given that prudential actions are not generally designed with welfare purposes in mind,

our analysis suggests that they should be used in conjunction with, e.g., redistributive �scal

policies, if they are to produce Pareto improving allocations along the adjustment path.

The model is rich and can be used to analyze other questions such as public sector

deleveraging or the consequences of sovereign shocks we do not address in the paper. In

addition, while we focus on monetary and capital prudential tools, the model also features

�scal and supervisory instruments, which can be used for stabilization purposes. An analysis

of this kind may carry important policy insights.

38

The model can be re�ned in many dimensions. For example, the di¤erences between the

retail and the investment banking sector can be made sharper by adding deposit insurance or

di¤erential prudential controls. Certain parameters can be made endogenous. For example,

there is some empirical evidence that banks take more risks when the interest rate is low. Mak-

ing valuation coe¢ cients function of the nominal interest rate may boost the real transmission

of �nancial shocks. The investment process in physical capital, can be enhanced by directly

linking it to the state of the loans market. One could consider adding �re sales when default

shocks are large and study policies that mitigate their real e¤ects. Finally, the entrepreneurial

sector has no net worth - entrepreneurial pro�ts are transferred on a period-by-period basis

back to patient households. If entrepreneurs retaining part of the pro�ts (see e.g. Bernanke,

Gentler and Gilchrist, 1999), collateral constraints become richer and may allow researchers

to examine complex �rm �nancing issues.

The international features of the model can also be improved. For example, the model

features no direct lending by foreign banks to domestic agents and banks retain national

characteristics in their asset side. One could also alter the way the government �nances its

de�cit to re�ect the fact that in some countries a large portion of government debt is held

domestically. We leave all these extensions to future work.

39

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45

Tables and �gures

Table 1a: Parameter values

Description Symbol Value

Steady state government expenditure to output ratio g 0:18

Steady state government debt to output ratio b 0:9

Share of imports !F 0:5

Elasticity of substitution for imports � 1:2

Elasticity of substitution for intermediate varieties � 6

Share of capital � 0:3

Depreciation rate:houses �H 0:025

Depreciation rate:capital �k 0:02

Returns to scale in house production 0:4

Share of patient households !s 0:7

Housing preference parameter vhs ; vhb 0:1

Housing adjustment cost, borrowers sHb 2

Housing adjustment cost, savers sHs 0:1

Risk aversion coe¢ cient � 1

External habit parameter h 0:8

Labour preference parameter �ns ; �nb 1

Inverse of the Frish elasticity ' 0:01

Price rigidity (probability to keep prices �xed) � 0:3

Investment adjustment costs, physical capital sk 0:1

Investment adjustment costs, housing sh 0:1

Size of the periphery n 0:2

Steady state policy rate REA 1:005

46

Table 1b: Parameter values

Description Symbol Value

Monetary policy, interest rate inertia �R 0:75

Monetary policy, in�ation targeting parameter � 0:5

Monetary policy, output targeting parameter Y 0:5

Monetary policy, �nancial targeting parameter Fin 0

Fiscal rule, debt targeting parameter t1 0:01

Fiscal rule, countercyclical parameter t2 0:0

Discount rate, patient households �s 0:996

Discount rate, impatient households �b 0:95

Discount rate, banks �m; �f 0:98

Discount rate, entrepreneurs �e 0:96

Speed of adjustment capital requirement, retail banks �m 0:9

Speed of deleveraging, investment banks �f 0:75

Speed of deleveraging, impatient households �b 0:75

Speed of deleveraging, entrepreneurs �e 0:6

Collateral valuation parameter, impatient households b0 0:7

Collateral valuation parameter, entrepreneurs e0 0:35

Risk-adjusted valuation parameter, households loans �Lb0 0:1

Risk-adjusted valuation parameter, interbank loans �IB0 0:01

Risk-adjusted valuation parameter, entrepreneur loans �Le0 0:5

Risk-adjusted valuation parameter, government loans �BP0 1

Countercyclical bu¤er parameter for banks �IB1 ; �BP1 0:00

Share of the periphery bonds in its portfolio !p 0:8

Share of the periphery bonds in core portfolio !�p 0:2

Financial integration � 0:35

Adjustment cost parameter, deposits as 0:75

Adjustment costs parameter, household and entrepreneur loans ab; ae 0:1

47

Table 2: Steady-States

Variable name (in per-capita) Ratio to Output

Consumption 0:79

Housing (patient households) 0:81

Housing (impatient households) 0:49

Capital stock 4:91

Capital investment 0:10

Household loans 0:44

Corporate loans 0:22

Deposits 1:07

Loans/Deposit ratio 0.66

Domestic bond holdings 0:48

Foreign bond holdings 0:12

Interbank loans to domestic banks 0:67

Interbank loans to foreign banks 0:74

Net taxes/transfer 0:18

Imports 0:50

48

Table 3: Theoretical volatilities and persistences

Variable name (in per-capita) Symbol Relative Standard Deviation AR(1) Coe¢ cient

House prices pH 0.62 0.89

Housing - patient households Hs 0.21 0.99

Housing - impatient households Hb 0.04 0.97

Consumption - patient households Cs 0.42 0.99

Consumption - impatient households Cb 0.42 0.99

Corporate loans Le 1.33 0.98

Household loans Lb 1.34 0.98

In�ation � 0.75 0.55

Output Y 1.00 0.78

Labor N 0.64 0.41

Investment I 4.46 0.68

Nominal interest rate REA 0.54 0.90

49

Table 4: Welfare

Household Firm Bank Risk Capital

Default Default Default PerceptionRequirement

Baseline simulations

Domestic Savers -632,44 -692,70 -692,75 -688,42 -676,52

Domestic Borrowers -94,09 -93,76 -93,83 -94,43 -96,12

Foreign Savers -1410,48 -1370,83 -1363,12 -1372,45 -1376,05

Foreign Borrowers -162,95 -159,73 -159,94 -159,88 -164,62

Home country -470,94 -513,02 -513,07 -510,22 -502,40

Foreign country -1036,22 -1007,50 -1002,16 -1008,68 -1012,62

Global -923,16 -908,60 -904,35 -908,99 -910,58

Changes with prudential monetary policy

Domestic savers -2,89 5,00 -0,08 32,13 0,55

Domestic borrowers -0,09 -0,20 0,03 -1,06 -0,03

Foreign savers 5,80 9,23 -1,10 54,24 -1,72

Foreign borrowers 0,06 -0,04 -0,04 -0,73 -0,03

Home country -2,04 3,44 -0,07 22,14 0,38

Foreign country 5,22 7,51 -0,85 27,97 0,80

Global 3,41 7,31 -0,64 34,86 0,96

Changes with prudential capital requirement

Domestic savers -14,43 -1,13 -0,04 -0,10 -0,19

Domestic borrowers 0,20 -0,01 0 -0,12 0,03

Foreign savers 8,75 0,83 0,10 1,29 0,24

Foreign borrowers 0,72 0,07 0 0,09 0,03

Home country -10,04 -0,79 -0,03 -0,81 -0,12

Foreign country 6,34 0,56 0,08 0,83 0,18

Global 3,06 0,18 0,05 0,59 0,12

50

Appendix A: The optimality conditions of the model

In this appendix we summarize the optimality conditions for the domestic economy in realterms. The conditions for the foreign economy are analogous and omitted. The equations wepresent are obtained using the market clearing conditions (61)-(62)-(63)-(66); the expressionfor the �x cost in production that makes branding �rm pro�ts equal to zero, andde�ating the expressions with the consumer price de�ator Pt. In addition, �scal variables are

expressed as a ratio to output. In this appendix, the following de�nitions hold, ds;t �Ds;tPt;

lb;t �Lb;tPt; lm;t �

Lm;tPt

;le;t �Le;tPt; ibf;t �

IBf;tPt

; ib�f;t �IB�f;tP �t

;ibf�;t �IBf�;tPt

;ib�f�;t �IB�f�;tP �t

;

bf;t �Bf;tPt;bf�;t �

Bf�;tPt

;b�f;t �B�f;tP �t

;b�f�;t �B�f�;tP �t

; rert �P �tPt; gt �

GtYt; tt �

TtYt; bt �

Bt=PtYt

;

�s;t � Pt�s;t; �b;t � Pt�b;t;wt �Wt

Pt;pHt �

PHtPt

The optimality conditions for the patient households are:

�s;t = (Cs;t � hCs;t�1)�� (74)

"ht �hsH

��s;t

�s;t+ Et

��s (1� �H)

�s;t+1�s;t

pHt+1

�= pHt + sHs

�Hs;tHs

� 1�

(75)

wt =�nsN

's;t

�s;t(76)

�sEt

��s;t+1�s;t

rs;t

�= 1 (77)

The trade-o¤ between the marginal utility of consumption and the marginal utility ofhousing in equation (75) is regulated by the relative price of the two goods, adjusted for thefact that housing is durable and yields utility services also in the next period. The trade-o¤between the marginal utility of consumption and leisure in equation (76), instead, dependson the real wage. Conditions (74) and (77) imply that the ratio of the marginal utility ofconsumption between two subsequent periods is related to the real rate on deposits.

51

The optimality conditions for the impatient households are:

�b;t = (Cb;t � hCb;t�1)�� (78)

pHt + sHb

�Hb;tHb

� 1�="ht �

hbH

��b;t

�b;t+

(1� �H) (1� �b)( b0�ibt )�b;tEt

"pHt+1rb;t

#+ �b (1� �H)Et

��b;t+1�b;t

pHt+1

�(79)

wt =�nbN

'b;t

�b;t(80)

1� �b;t = �bEt

��b;t+1�b;t

�rb;t � �b�b;t+1

��(81)

lb;t = �blb;t�1 + (1� �b)�( b0�

ibt )Et

pHt+1(1��H)Hb;trb;t

� "bt�

(82)

Cb;t + ttYt +ACHb;t + p

Ht (Hb;t � (1� �H)Hb;t�1) + rb;tlb;t�1 � "bt = lb;t + wtNb;t (83)

The intratemporal and intertermporal trade-o¤s for the patient and the impatient house-holds are similar. The main di¤erence is that now the consumption housing trade-o¤ alsoincludes a term re�ecting the collateral constraint that impatient households face. Note thatwhen the collateral constraint is not binding, �b;t = 0, and (79) is the same as (75) apart froma di¤erent discount factor. Notice also that (78) and (81) indicate that when the borrowingconstraint is binding, the ratio of the marginal utility of consumption in two subsequent peri-ods is related not only to the real borrowing rate but also to the shadow price of the borrowingconstraint in those two periods. This is due to the persistence present in the borrowingconstraints. Once again, if �b;t = 0 for all t; (81) is similar to (77). Finally, equations (82)and (83) represent, respectively, the borrowing and the budget constraints of the impatienthousehold.

52

The optimality conditions for the entrepreneurial sector are:

1 = qe;t

"Ikt �

sk2

�Ie;tIe;t�1

� 1�2� sk

�Ie;tIe;t�1

� 1�

Ie;tIe;t�1

!

+ �eEt

"qe;t+1

�s;t+1�s;t

sk

�Ie;t+1Ie;t

� 1��

Ie;t+1Ie;t

�2#(84)

qe;t = �eEt

��s;t+1�s;t

(�pXt+1

�Yt+1 +

1

� � 1Y�K�1e;t + qe;t+1(1� �k))

�+ � (1� �e) ( e0�iet )Et

��e;tre;t

pXt+1

�Yt+1 +

1

� � 1Y�K�1e;t

�(85)

wt = pXt (1� �)Yt +

1��1Y

Nt(86)

1� �e;t = �eEt

��s;t+1�s;t

�re;t � �e�e;t+1

��(87)

Kt = Ie;t

""Ikt �

sk2

�Ie;tIe;t�1

� 1�2#

+ (1� �k)Kt�1 (88)

le;t = �ele;t�1 + (1� �e)

0@( e0�iet )Et pXt+1�Yt+1 +

1��1Y

�� wt+1Nt+1

re;t� "et

1A (89)

rt =

(Yt+1

��1Y )�pxt

Kt�1+ qe;t(1� �k)

qe;t�1(90)

The �rst two equations describe the intertermporal trade-o¤s the entrepreneurs facein selecting investment and capital via the Tobin�s Q. Note that in equation (85) theTobin�Q, qe;t ,depends on the lagrange multiplier on the borrowing constraint. Thus, the�nancial friction that the borrowing constraint implies will have real repercussions viathe capital decision of entrepreneurs. The next equation is the optimal labor demand bythe sector. As with impatient households, the ratio of marginal utility of dividends betweentwo subsequent periods is related to the real borrowing costs and to the shadow price of theborrowing constraints in those two periods. When �e;t = 0; for all t, equation (87) collapsesto the standard conditions linking the ratio of marginal utility of dividends in two subsequentperiods to the real borrowing rate. Finally, note that equation (88) gives the law of motionof capital and equation (89) the borrowing constraint faced by entrepreneurs. (90) de�nesthe returns to capital.

The condition for intermediate goods production is:

Yt +1

� � 1Y = "zt (Kt�1)� (Nt)

1�� (91)

53

where the �xed costs are taken into account. The optimal pricing conditions are:

$t � ��s (�)�� Et�

�t+1$t+1 + (�s;t) p

Xt

�pYt��Yt (92)

t � ��s (�)1�� Et�

��1t+1 t+1 + (�s;t)

�pYt��Yt (93)

pYt =

"(1� �)

��

� � 1$t

t

�1��+ �

�(�t)

�1�pYt�1

�(1��)# 11��

(94)

1 = (1� !F )�pYt�1��

+ !F

�rertp

Y �t

�1��(95)

Equation (94) is a standard Philips�curve and (95) describes the composition of theprice de�ator. The optimality conditions for the housing sector are:

Ht � (1� �h)Ht�1 =��Iht � Sh

�Ih;tIh;t�1

��I h;t (96)

pHt

�Iht �

sh2

�Ih;tIh;t�1

� 1�2!

I �1h;t � pHt sh�

Ih;tIh;t�1

� 1�

I h;tIh;t�1

+

�sEt

"�s;t+1�s;t

pHt+1sh

�Ih;t+1Ih;t

� 1�I +1h;t+1

I2h;t

#= 1 (97)

Equation (96) is the production function for new housing while equation (97) is theoptimality condition for housing investment weighting the gains of producing new housesagainst the cost of producing one extra unit of housing and adjusting the existing stock.

The optimality conditions for the retail banking sector are:

1� �m;t + �m�mEth�s;t+1�s;t

�m;t+1

i� as

�dm;tdm

� 1�= �mEt

h�s;t+1�s;t

rs;t

i(98)

1� �m;t(1 + (1� �m) �Lbt ) + ab

�lm;tlm� 1�= �mEt

h�s;t+1�s;t

�rb;t � �m�m;t+1

�i(99)

1� �m;t(1� (1� �m) �IBt ) = �mEt

h�s;t+1�s;t

�rEAt � �m�m;t+1

�i(100)

!sdt � �m!sdt�1 = ibt + (1� !s) lb;t � �m (ibt�1 + (1� !s) lb;t�1)

� (1� �m)��IBt ibt + �

Lbt (1� !s) lbt � (1� �0"

�t ) "

ft � �0"

�t rert"

f�

t � (1� !s) "bt�(101)

�IBt � �IB0"�t + �

IB1

�ibf;t +

1�nn ibf�;t

�=Yt�

ibf +1�nn ibf�

�=Y

� 1!!

(102)

�Lbt ���Lb0"�mt + �Lb1

�lm;t=Ytlm=Y

� 1��

(103)

Equations (98)-(100) provide arbitrage relationships for rs;t; rb;t and rEAt . For example,absent adjustment costs, (99) and (100) state that impatient household real borrowing ratemay be di¤erent from the real area wide real policy rate only to the extent that the valuationcoe¢ cients �Lbt and �IBt di¤er. Note also from (98) that deposits have an additional functionfor retail banks because they in�uence the leverage constraint in di¤erent periods. Note that

54

equation (101) is the LTV constraint for retail banks, while (102)-(103) describe thestructure of the valuation parameters.

The optimality conditions for the investment banking sector are:

1� �f;t + �f�fEth�s;t+1�s;t

�f;t+1

i= �fEt

h�s;t+1�s;t

rEAt

i(104)

1� ��f;t + �f�fEth�s;t+1�s;t

��t+1�t+1

��f;t+1

i= �fEt

h�s;t+1�s;t

rEAt

i(105)

1��1� �f

��Let

�(1� �0"

�t ) �f;t + �0"

�t ��f;t

�+ ae

�lf;tlf� 1�= �fEt

h�s;t+1�s;t

re;t

i(106)

1��1� �f

��BPt

�(1� �0"

�t ) �f;t + �0"

�t ��f;t

�= �fEt

��s;t+1�s;t

�!p;trt + (1� !p;t)

rert+1rert

r�t

��(107)

�Let � �Le0"�ft � �Le1

lft =p

Yt Yt

lf=pY Y� 1!!

(108)

�BPt �

0@�BP0"�ft � �BP1

0@�bft +

1�nn rertb

f�

t

�=pYt Yt�

bf + 1�nn rerb�f

�=pY Y

� 1

1A1A (109)

1� nn

rerb�f;t =1� !p;t!p;t

bf;t (110)

ibf�

t = �f (ibt�1)f� +

�1� �f

��0"

�t

lft �

Let

rert+ �BPt

bftrert

+1� nn

bf�

t

!� ("e;t � "f;t)

rert

!(111)

ibft = �f ibft�1 +

�1� �f

�(1� �0"

�t )

��Let l

ft + �

BPt

�bft +

1� nn

rertbf�

t

�� "e;t + "f;t

�(112)

(104)-(107) provide another set of arbitrage conditions linking re;t; rp;t rEAt and rBPt : Notethat the �rst two conditions imply investment banks should be indi¤erent between borrowingfrom domestic or from foreign retail banks as long as the shadow price of the foreign leverageconstraints (111) re�ects the shadow price of the domestic leverage constraint (112) and thein�ation di¤erentials.

The optimality conditions for the problem of the government are :

gt + rt�1bt�1

�YtYt�1

��1= bt + tt (113)

gt = g"gt (114)

btYt = bf;t + bf�;t (115)

ln

�ttt

�= t1 ln

�bt�1b

�+ t2 ln

�YtY

�+ "�t (116)

Equation (113) is the budget constraint and (116) the �scal rule. (114) de�nes whatgovernment expenditure is and (115) is the supply of domestic bonds.

55

The market clearing conditions are:

Ct = !sCs;t + (1� !s)Cb;t (117)

Ht = !sHs;t + (1� !s)Hb;t (118)

Nt = !sNs;t + (1� !s)Nb;t (119)

It = Ie;t + Ih;t (120)

pYt Yt = Ct + It + gtYt +1� nn

pYt YM�;t � rertpY�

t Y �M;t (121)

Y �M;t = !F

�rertp

Y �t

���(Ct + It + gtYt) (122)

YM�;t = !�F

�pYtrert

���(C�t + I

�t + g

�t Y

�t ) (123)

Equation (121) is the national account identity, while equations (122) and (123) de�newhat imports and exports are. Balance of payments equilibrium requires:

1� nn

��rertb

�f;t � rertr�t�1b�f;t�1

�+�ibf�;t � rEAt�1ibf�;t�1

�+ �0"

�t rert"f�;t

��h(bf�;t � rt�1bf�;t�1) +

�rertib

�f;t � rertr

EA;�t�1 ib�f;t�1

�+ �0"

�t "f;t

i=

1� nn

pYt YM�;t � rertpY�

t Y �M;t (124)

Imports, exports and the CA balance are de�ned as

Impt = pY�

t Y �M;t (125)

Expt = pYt1� nn

YM�;t (126)

CAt =Expt � Impt

Yt(127)

The following Fisher equations de�ne real rates for various assets:

rs;t = ��1t Rs;t (128)

rb;t = ��1t Rb;t (129)

re;t = ��1t Re;t (130)

rt = ��1t Rt (131)

rEAt = ��1t REAt (132)

rEA;�t = (��t )�1REAt (133)

56

The central bank policy rule is:

ln

�REAtREA

�= ln

" REAt�1REA

!�R[

��EAt�EA

� � �Y EAt

Y EA

� Y �finEAtfinEA

� fin#1��R+ "Rt (134)

�EAt � n�t + (1� n)��t (135)

Y EAt � nYt + (1� n)Y �t (136)

finEAt � n(1� !s) lb;t + le;t

Yt+ (1� n)

(1� !�s) l�b;t + l�e;tY �t

(137)

Finally, the processes for the exogenous shocks hitting the economy are:

"bt = �b"bt�1 + ub;t (138)

"et = �e"et�1 + ue;t (139)

"ft = �f"ft�1 + uf;t (140)

ln�"ibt

�= �ib ln

�"ibt�1

�+ uib;t (141)

ln�"iet�= �ie ln

�"iet�1

�+ uie;t (142)

ln�"ift

�= �if ln

�"ift�1

�+ uif;t (143)

ln�"imt�= �im ln

�"imt�1

�+ uim;t (144)

ln ("zt ) = �z ln�"zt�1

�+ uz;t (145)

ln�"ht

�= �h ln

�"ht�1

�+ uh;t (146)

ln�"Ikt

�= �Ik ln

�"Ikt�1

�+ uIk;t (147)

ln�"Iht

�= �Ih ln

�"Iht�1

�+ uIh;t (148)

ln ("gt ) = �g ln�"gt�1

�+ ug;t (149)

"Rt = �R"Rt�1 + uR;t (150)

ln ("�t ) = �� ln�"�t�1

�+ u�;t (151)

"�t = ��"�t�1 + u�;t (152)

Overall, there are 55 structural equations for each country, plus 4 (common) monetarypolicy equations, a (common) balance of payments equation, and 29 autoregressive equationsdescribing the behavior of exogenous disturbances. Thus, there are 144 equations in themodel which determine 144 endogenous variables as a function of the 29 exogenous shocks.

To �nd a solution to the model, we use perturbation methods. That is, given that theoptimality conditions are of the form Ef(xt+1; xt; xt�1; �t+1; �t;�) = 0; where xt are theendogenous variables, �t the exogenous shocks, � the structural parameters and f is a genericnon-linear function, we seek for a solution of the form xt = g(xt�1; �t;�). Since g is unknownwe take a �rst order Taylor expansion of g and of f and match the coe¢ cients.

57

 

 

 

 

 

 

W* tN

* t  

Bf*,t  

RtBf*,t  

IB*f*,t  

REAtIB*f*t  

IB*f,t  

REAtIB*ft  

IBf*,t  

REAtIBf*t  

IBf,t  

REAtIBft  

Bf,t  

RtBf,t  

P*tI*e*,t  

T*t  R*

s,tD*s*,

t  

D*s*,t  

QX*tX*t  

P*tC*s*,t  ,  P*tC*b*,t  

PH*tΔH*s*,t  ,  PH*t ΔH*

b*,t  

P*tG*t  

PY* tY

* D,t  

P*tI*

h*,t  

PYtY

M*,t  

B*f,t  

R*tB*

f,t  

R*tB*

f*,t  

B*f*,t  

R*b,tL*b*,t  

L*b*,t  

R*e,tL*e*,t  

L*e*,t  

Re,tLe,t  

Le,t  

Lb,t  Rb,tLb,t  

Ds,t  Rs,tDs,t  

Tt  

WtN

t  

PtGt  

P tI h,

t  PtCs,t  ,PtCb,t  

PtIe,t  

PHtΔHs,t  ,  PHtΔHb,t  

QXtXt  

PYtY

D,t  

Saving              Households  

House  Producing  Firms  

Government  

Borrowing  Households  

Entrepreneurs  

Goods  Distributors  

Branding  Firms  &    Wholesalers  

Retail  Banks  

Common  Monetary  Authority:  REAt  

Government*  

Borrowing  Households*  

Entrepreneurs*  

Goods  Distributors*  

Branding  Firms  &    Wholesalers*  

Retail  Banks*  

House  Producing  Firms*  

Saving              Households*  

PY* tY

* M,t  

Investment  Banks  

Investment  Banks*  

5 10 15-10

-5

0Commercial Loans D

5 10 15-0.3

-0.2

-0.1

0

Commercial Loans F

5 10 15-10

-5

0Mortgages D

5 10 15

-0.4-0.3-0.2-0.1

0

Mortgages F

5 10 15

-0.8-0.6-0.4-0.2

0

Deposits D

5 10 15

-0.3

-0.2

-0.1

0

0.1Deposits F

5 10 15

-0.2

-0.1

0

Consumption D

5 10 15

-0.4

-0.2

0Consumption F

5 10 15

-8

-6

-4

-2

0Output D

5 10 15-3

-2

-1

0

Output F

5 10 15-10

-5

0Labor D

5 10 15

-3-2-101

Labor F

5 10 15-30

-20

-10

0

10Investment D

5 10 15-60

-40

-20

0

Investment F

5 10 15

-3

-2

-1

0

1Export D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks

5 10 15

-6

-4

-2

0Import D

5 10 15-15

-10

-5

0Inflation D

5 10 15

-4

-2

0

2

Inflation F

5 10 15-40

-20

0

20

Net Interbank loans

5 10 15-0.8-0.6-0.4-0.2

00.2

Capital Return D

5 10 15-0.5

0

0.5Capital Return F

5 10 15

-0.4-0.3-0.2-0.1

0

Real Wage D

5 10 15

-1

-0.5

0Real Wage F

5 10 15

-0.8-0.6-0.4-0.2

0Policy Rate

5 10 150

5

10

15

Deposit Rate D

5 10 15-2

0

2

4

Deposit Rate F

5 10 150

5

10

15

Mortgage Rate D

5 10 15-2

0

2

4

Mortgage Rate F

5 10 150

5

10

15

Commercial Loan Rate D

5 10 15-2

0

2

4

Commercial Loan Rate F

5 10 150

5

10

15

Bond Rate D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks

5 10 15-2

0

2

4

Bond Rate F

5 10 15-4

-3

-2

-1

0Output EA

5 10 15

-4-3-2-10

Inflation EA

5 10 15

-0.8-0.6-0.4-0.2

0Policy Rate

5 10 15

-0.2

-0.1

0

House Prices D

5 10 15

-1

-0.5

0House Prices F

5 10 15-0.1

0

0.1

Capital Price D

5 10 15

-0.2

-0.1

0

0.1

Capital Price F

5 10 15-2-1012

x 10-13RER

5 10 15

-0.2

-0.1

0

Consumption Savers D

5 10 15

-0.2-0.15-0.1

-0.050

Consumption Borrowers D

5 10 15

-0.4

-0.2

0Consumption Savers F

5 10 15

-0.4

-0.2

0Consumption Borrowers F

5 10 15

-15

-10

-5

0

Labor Savers D

5 10 15

-3

-2

-1

0

Labor Borrowers D

5 10 15

-6

-4

-2

0

Labor Savers F

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks5 10 15

-0.2

0

0.2

0.4

0.6Labor Borrowers F

5 10 15

-0.1

-0.05

0Housing Savers D

5 10 150

0.1

0.2

Housing Borrowers D

5 10 15-0.2

-0.15

-0.1

-0.05

0Housing Savers F

5 10 15-0.01

0

0.01

0.02

Housing Borrowers F

5 10 150

100

200

Retail Bank Capital D

5 10 150

100

200

Retail Bank Capital F

5 10 150

1

2

3

Retail Bank Assets D

5 10 150

1

2

3

Retail Bank Assets F

5 10 15

-0.8-0.6-0.4-0.2

0

Retail Bank Liabilities D

5 10 15

-0.3

-0.2

-0.1

0

0.1Retail Bank Liabilities F

5 10 15

0

50

100

150

Investment Bank Capital D

5 10 15-100

-50

0

50

100

Investment Bank Capital F

5 10 150

10

20

30

Investment Bank Assets D

5 10 15-4-2024

Investment Bank Assets F

5 10 150

10

20

30

Investment Bank Liabilities D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks

5 10 15

-2

0

2

4

Investment Bank Liabilities F

5 10 15-10

-5

0Commercial Loans D

5 10 15-10

-5

0Commercial Loans F

5 10 15

-8

-6

-4

-2

0Mortgages D

5 10 15

-8

-6

-4

-2

0Mortgages F

5 10 15

-0.15

-0.1

-0.05

0

Deposits D

5 10 15-0.08

-0.06

-0.04

-0.02

0

Deposits F

5 10 15-0.08

-0.06

-0.04

-0.02

0Consumption D

5 10 15-0.2

-0.15

-0.1

-0.05

0Consumption F

5 10 15-3

-2

-1

0Output D

5 10 15-1.5

-1

-0.5

0

Output F

5 10 15

-3

-2

-1

0Labor D

5 10 15

-1.5

-1

-0.5

0

Labor F

5 10 15

-10

-5

0

Investment D

5 10 15-20

-15

-10

-5

0

Investment F

5 10 15-1.5

-1

-0.5

0

Export D

Risk Perception Shock Capital Requirement Shock Risk Perception Shock (both countries)

5 10 15

-2

-1

0Import D

5 10 15

-4

-3

-2

-1

0Inflation D

5 10 15-0.8

-0.6

-0.4

-0.2

0

0.2Inflation F

5 10 15

-1

0

1

2

3

Net Interbank loans

5 10 15

-0.2

-0.1

0

Capital Return D

5 10 15-0.2

-0.1

0

0.1

Capital Return F

5 10 15-0.2

-0.15

-0.1

-0.05

0

Real Wage D

5 10 15

-0.4

-0.3

-0.2

-0.1

0

Real Wage F

5 10 15

-0.3

-0.2

-0.1

0

Policy Rate

5 10 150

1

2

3

4

Deposit Rate D

5 10 15-0.2

0

0.2

0.4

0.6

0.8Deposit Rate F

5 10 15

0

2

4

Mortgage Rate D

5 10 15

-0.5

0

0.5

Mortgage Rate F

5 10 15

0

2

4

Commercial Loan Rate D

5 10 15-1

-0.5

0

0.5

Commercial Loan Rate F

5 10 150

1

2

3

4

Bond Rate D

Risk Perception Shock Capital Requirement Shock Risk Perception Shock (both countries)

5 10 15-0.2

0

0.2

0.4

0.6

0.8Bond Rate F

5 10 15

-1.5

-1

-0.5

0

Output EA

5 10 15

-1

-0.5

0

Inflation EA

5 10 15

-0.3

-0.2

-0.1

0

Policy Rate

5 10 15-0.15

-0.1

-0.05

0

House Prices D

5 10 15

-0.3

-0.2

-0.1

0

House Prices F

5 10 15-0.05

0

0.05Capital Price D

5 10 15

-0.05

0

0.05

Capital Price F

5 10 15

-1

0

1

2x 10

-14RER

5 10 15

-0.08

-0.06

-0.04

-0.02

0Consumption Savers D

5 10 15

-0.08

-0.06

-0.04

-0.02

0Consumption Borrowers D

5 10 15

-0.2

-0.15

-0.1

-0.05

0Consumption Savers F

5 10 15

-0.2

-0.15

-0.1

-0.05

0Consumption Borrowers F

5 10 15

-6

-4

-2

0

Labor Savers D

5 10 15

0

0.5

1

1.5Labor Borrowers D

5 10 15

-2

-1

0

Labor Savers F

Risk Perception Shock Capital Requirement Shock Risk Perception Shock (both countries)

5 10 15-0.2

0

0.2

0.4

0.6

Labor Borrowers F

5 10 15

-0.04

-0.02

0

Housing Savers D

5 10 15

0

0.05

0.1Housing Borrowers D

5 10 15

-0.08

-0.06

-0.04

-0.02

0Housing Savers F

5 10 15

0

0.02

0.04

Housing Borrowers F

5 10 150

10

20

30

Retail Bank Capital D

5 10 15

0

5

10

Retail Bank Capital F

5 10 15-0.2

0

0.2

0.4

0.6

Retail Bank Assets D

5 10 15-0.1

0

0.1

Retail Bank Assets F

5 10 15

-0.15

-0.1

-0.05

0

Retail Bank Liabilities D

5 10 15-0.08

-0.06

-0.04

-0.02

0

Retail Bank Liabilities F

5 10 15

0

20

40

60Investment Bank Capital D

5 10 15-10

-5

0

Investment Bank Capital F

5 10 150

5

10Investment Bank Assets D

5 10 15

-0.4

-0.2

0

0.2Investment Bank Assets F

5 10 150

1

2

3

Investment Bank Liabilities D

Risk Perception Shock Capital Requirement Shock Risk Perception Shock (both countries)

5 10 15

-0.2

-0.1

0

0.1

0.2

Investment Bank Liabilities F

5 10 15-5

-4

-3

-2

-1

0

1Current Account/GDP D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks

5 10 150

5

10

15

20

25

30Government Debt/GDP D

5 10 15

-2

0

2

4

6

8Government Debt/GDP F

5 10 15-1.5

-1

-0.5

0

Risk Perception Shock Capital Requirement Shock

5 10 150

1

2

3

4

5

6

7

8

9

5 10 15-0.5

0

0.5

1

1.5

5 10 15

-15

-10

-5Mortgages D

5 10 15-0.8-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15-0.25-0.2

-0.15-0.1

-0.05

Consumption D

5 10 15-40

-20

0

Investment D

5 10 15

-6-4-20Export D

5 10 15

-15-10-50Inflation D

5 10 15-0.05

00.050.1

0.15

5 10 15

-15

-10

-5

5 10 15-1.5

-1-0.5

0

5 10 15

-0.15

-0.1

-0.05

5 10 15

-10

-5

0

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15-0.1

00.10.2

5 10 15

-0.2-0.1

0

5 10 15-4

-2

5 10 150

0.050.1

0.15

5 10 15-20

-10

0

5 10 15-4

-2

0

5 10 15

-4

-2

0

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15-0.08

-0.06

-0.04

5 10 15-4-202

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15

-0.38

-0.36

-0.34

5 10 15-3

-2

-1

5 10 15-0.06

-0.04

baseline calibration Domestic country twice as large

5 10 15-15-10-50

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15

-4

-2

Household default

Commercial default

Bank default

Risk Perception

Capital requirment

5 10 15

-10

-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15

-0.3

-0.2

-0.1

Consumption D

5 10 15-60-40-20

0

Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15-0.05

00.050.1

0.15

5 10 15-10

-5

5 10 15-1.5

-1

-0.5

0

5 10 15-0.15

-0.1

-0.05

5 10 15-20

-10

0

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15-0.3-0.2-0.1

00.1

5 10 15-0.3-0.2-0.1

0

5 10 15-3

-2

-1

5 10 15-0.2

-0.1

0

5 10 15-40

-20

0

5 10 15-4

-2

0

5 10 15

-4

-2

0

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15

-10

-5

0

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15-0.2

-0.1

5 10 15-0.42

-0.4

-0.38

5 10 15-3

-2

-1

5 10 15

-0.15-0.1

-0.05

5 10 15-30-20-10

0

5 10 15-2.5

-2-1.5

-1-0.5

baseline calibration Lower financial integration (=0.05)

5 10 15

-4

-2

Bankdefault

Capitalrequirment

Householddefault

Commercialdefault

RiskPerception

5 10 15-25-20-15-10-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15-0.25-0.2

-0.15-0.1

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

00.050.1

5 10 15-20

-10

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15-6-4-20

5 10 15

-1

-0.5

0

5 10 15-2

-1

0

5 10 15-0.1

-0.050

0.05

5 10 15-0.1

-0.05

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.04

5 10 15-8-6-4-20

5 10 15-4

-2

0

5 10 15-1.2

-1-0.8-0.6-0.4-0.2

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15-0.08-0.06-0.04-0.02

5 10 15-4

-2

0

2

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15-0.38-0.36-0.34-0.32-0.3

-0.28

5 10 15-3

-2

-1

5 10 15-0.03

-0.02

-0.01

baseline calibration 50% lower LTV for Households and firms

5 10 15

-10

-5

0

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15

-4

-2

Bankdefault

Capitalrequirment

Householddefault

Commercialdefault

RiskPerception

5 10 15

-10

-5

Mortgages D

5 10 15-1

-0.5

0

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15

-0.25-0.2

-0.15-0.1

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

-0.050

0.050.1

0.15

5 10 15

-10

-5

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15-6-4-20

5 10 15

-1

-0.5

0

5 10 15-2

-1

0

5 10 15-0.15-0.1

-0.050

0.05

5 10 15-0.15

-0.1

-0.05

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.04

5 10 15-8-6-4-20

5 10 15-4

-2

0

5 10 15-1.2

-1-0.8-0.6-0.4-0.2

5 10 15-10

-5

5 10 15

-10

-8

-6

5 10 15-1.5

-1-0.5

0

5 10 15-0.14-0.12-0.1

-0.08-0.06-0.04

5 10 15-6-4-202

5 10 15-1.5

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15

-0.6

-0.5

-0.4

5 10 15-3

-2

-1

5 10 15-0.032-0.03

-0.028-0.026-0.024-0.022

baseline calibration 50% faster deleveraging for Households and Firms

5 10 15

-10

-5

0

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15

-4

-2

Bankdefault

Capitalrequirment

Householddefault

Commercialdefault

RiskPerception

5 10 15-10

-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15-0.25-0.2

-0.15-0.1

-0.05

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

0

0.05

0.1

5 10 15-10

-5

5 10 15-1.5

-1

-0.5

0

5 10 15

-0.12-0.1

-0.08-0.06-0.04

5 10 15-8-6-4-20

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15-0.1

00.10.2

5 10 15-0.1

00.10.2

5 10 15

-2

-1

0

5 10 15-0.15-0.1

-0.050

0.05

5 10 15

-10

-5

0

5 10 15-4

-2

0

5 10 15-1012

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15-0.08-0.06-0.04-0.02

5 10 15-4

-2

0

2

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15

-0.4

-0.38

5 10 15-3

-2

-1

5 10 15-0.04

-0.03

-0.02

baseline calibration 50% faster deleveraging for banks

5 10 15

-10

-5

0

5 10 15-3

-2

-1

5 10 15-5-4-3-2-1

Bankdefault

Householddefault

Commercialdefault

RiskPerception

Capitalrequirment

5 10 15-10

-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15-0.25-0.2

-0.15-0.1

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

0

0.05

0.1

5 10 15-10

-5

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15-6-4-20

5 10 15

-1

-0.5

0

5 10 15-2

-1

0

5 10 15-0.1

-0.050

0.05

5 10 15-0.1

-0.05

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.04

5 10 15-8-6-4-20

5 10 15-4

-2

0

5 10 15-1.2

-1-0.8-0.6-0.4-0.2

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15

-0.08

-0.06

-0.04

5 10 15-4

-2

0

2

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.15

-0.1

-0.05

5 10 15-0.55-0.5

-0.45-0.4

5 10 15-4

-2

5 10 15

-0.05-0.04-0.03

baseline calibration 50% higher Capital Requirements

5 10 15-20

-10

0

5 10 15

-3-2-1

5 10 15

-6-4-2

Capitalrequirment

RiskPerception

Bankdefault

Commercialdefault

Householddefault

5 10 15-10

-5Mortgages D

5 10 15-1

-0.5

0

Commercial Loans D

5 10 15

-10

-5

0Output D

5 10 15-0.4

-0.2

Consumption D

5 10 15-40

-20

0

Investment D

5 10 15

-10

-5

0Export D

5 10 15

-20

-10

0Inflation D

5 10 15

0

0.05

0.1

5 10 15-10

-5

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15-6-4-20

5 10 15

-1

-0.5

0

5 10 15-2

-1

0

5 10 15-0.1

-0.050

0.05

5 10 15-0.1

-0.05

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.04

5 10 15-8-6-4-20

5 10 15-4

-2

0

5 10 15

-1

-0.5

0

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1.5-1

-0.50

5 10 15-0.1

-0.05

5 10 15-6-4-202

5 10 15

-1.5-1

-0.50

5 10 15

-3-2-10

5 10 15

-0.1

-0.05

5 10 15

-0.39

-0.38

-0.37

5 10 15-3

-2

-1

5 10 15

-0.03

-0.025

-0.02

baseline calibration Share of borrowing households (1-s=0.5)

5 10 15

-10

-5

0

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15-5-4-3-2-1

Commercialdefault

Householddefault

Bankdefault

RiskPerception

Capitalrequirment

5 10 15-5

-4

-3

-2

-1

0

1Current Account/GDP D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks

5 10 150

5

10

15

20

25

30Government Debt/GDP D

5 10 15-3

-2

-1

0

1

2

3

4

5

6

7

8Government Debt/GDP F

5 10 15

-1

-0.8

-0.6

-0.4

-0.2

0

Risk Perception Shock Capital Requirements Shock

5 10 150

1

2

3

4

5

6

7

8

5 10 15

0

0.2

0.4

0.6

0.8

1

1.2

Tighter Fiscal Policy

5 10 15-14-12-10-8-6

Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15

-10

-5

0Output D

5 10 15-0.25

-0.2

-0.15

-0.1

Consumption D

5 10 15-60-40-20

020

Investment D

5 10 15-8-6-4-20

Export D

5 10 15

-15

-10

-5

0Inflation D

5 10 15-0.05

0

0.05

0.1

5 10 15-14-12-10-8-6

5 10 15

-1

-0.5

0

5 10 15

-0.15

-0.1

-0.05

5 10 15-10

-5

0

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15-0.15-0.1

-0.050

0.05

5 10 15-0.25-0.2

-0.15-0.1

-0.05

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.040.06

5 10 15-10

-5

0

5 10 15-6

-4

-2

0

5 10 15

-1.5

-1

-0.5

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15

-0.08

-0.06

-0.04

5 10 15-6-4-202

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15-0.12

-0.1

-0.08

-0.06

5 10 15

-0.38

-0.36

-0.34

5 10 15-3

-2

-1

5 10 15

-0.06-0.05-0.04-0.03

baseline calibration Lower import share (ωF=0.3)

5 10 15

-15

-10

-5

0

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15

-4-3-2-1

Commercialdefault

Household

default

Bank

default

Risk

Perception

Capital

requirment

5 10 15-10

-5

0Commercial Loans D

5 10 15

-0.4

-0.2

0

Commercial Loans F

5 10 15-10

-5

0Mortgages D

5 10 15

-0.6

-0.4

-0.2

0

Mortgages F

5 10 15

-1

-0.5

0

Deposits D

5 10 15

-0.3

-0.2

-0.1

0

0.1Deposits F

5 10 15-0.3

-0.2

-0.1

0

Consumption D

5 10 15

-0.8

-0.6

-0.4

-0.2

0Consumption F

5 10 15

-10

-5

0Output D

5 10 15

-6

-4

-2

0Output F

5 10 15-15

-10

-5

0Labor D

5 10 15-8

-6

-4

-2

0

Labor F

5 10 15

-40

-20

0

Investment D

5 10 15-100

-50

0Investment F

5 10 15

-4

-2

0

Export D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks Joint default shock

5 10 15

-10

-5

0Import D

5 10 15

-15

-10

-5

0Inflation D

5 10 15

-4

-2

0

2

Inflation F

5 10 15-40

-20

0

20

Net Interbank loans

5 10 15

-1

-0.5

0

Capital Return D

5 10 15-1

-0.5

0

0.5

Capital Return F

5 10 15

-0.8

-0.6

-0.4

-0.2

0

Real Wage D

5 10 15-2

-1.5

-1

-0.5

0Real Wage F

5 10 15

-1.5

-1

-0.5

0Policy Rate

5 10 150

5

10

15

Deposit Rate D

5 10 15-2

0

2

4

Deposit Rate F

5 10 150

5

10

15

Mortgage Rate D

5 10 15-2

0

2

4

Mortgage Rate F

5 10 150

5

10

15

Commercial Loan Rate D

5 10 15-2

0

2

4

Commercial Loan Rate F

5 10 150

5

10

15

Bond Rate D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks Joint default shock5 10 15

-2

0

2

4

Bond Rate F

5 10 15-8

-6

-4

-2

0Output EA

5 10 15-6

-4

-2

0Inflation EA

5 10 15

-1.5

-1

-0.5

0Policy Rate

5 10 15

-0.4

-0.2

0

House Prices D

5 10 15

-1.5

-1

-0.5

0House Prices F

5 10 15

-0.1

0

0.1

0.2Capital Price D

5 10 15-0.4

-0.2

0

0.2

Capital Price F

5 10 15-15

-10

-5

0

5x 10-14RER

5 10 15-0.3

-0.2

-0.1

0

Consumption Savers D

5 10 15

-0.2

-0.1

0

Consumption Borrowers D

5 10 15

-0.8

-0.6

-0.4

-0.2

0Consumption Savers F

5 10 15

-0.8

-0.6

-0.4

-0.2

0Consumption Borrowers F

5 10 15

-20

-10

0

Labor Savers D

5 10 15

-3

-2

-1

0

Labor Borrowers D

5 10 15

-10

-5

0

Labor Savers F

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks Joint default shock

5 10 15-0.2

00.20.40.60.8

Labor Borrowers F

5 10 15

-0.15

-0.1

-0.05

0Housing Savers D

5 10 150

0.1

0.2

0.3

Housing Borrowers D

5 10 15

-0.3

-0.2

-0.1

0Housing Savers F

5 10 15-0.01

0

0.01

0.02

Housing Borrowers F

5 10 150

100

200

300

400

Retail Bank Capital D

5 10 150

100

200

Retail Bank Capital F

5 10 150

2

4

6Retail Bank Assets D

5 10 150

1

2

3

Retail Bank Assets F

5 10 15

-1

-0.5

0

Retail Bank Liabilities D

5 10 15

-0.3

-0.2

-0.1

0

0.1Retail Bank Liabilities F

5 10 15

0

50

100

150

Investment Bank Capital D

5 10 15-100

-50

0

50

100

Investment Bank Capital F

5 10 150

10

20

30

Investment Bank Assets D

5 10 15-4

-2

0

2

4

Investment Bank Assets F

5 10 150

10

20

30

Investment Bank Liabilities D

Default Shock for Households Default Shock for Entrepreneurs Default Shock for Banks Joint default shock5 10 15

-2

0

2

4

Investment Bank Liabilities F

5 10 15-10

-5

0Commercial Loans D

5 10 15-0.15

-0.1

-0.05

0

Commercial Loans F

5 10 15

-8

-6

-4

-2

0Mortgages D

5 10 15

-0.2

-0.1

0Mortgages F

5 10 15

-0.15

-0.1

-0.05

0

Deposits D

5 10 15-0.03

-0.02

-0.01

0

0.01Deposits F

5 10 15

-0.1

-0.05

0Consumption D

5 10 15

-0.2

-0.1

0Consumption F

5 10 15-4

-3

-2

-1

0Output D

5 10 15-2

-1.5

-1

-0.5

0

Output F

5 10 15

-4

-2

0Labor D

5 10 15

-2

-1

0

Labor F

5 10 15

-15

-10

-5

0

Investment D

5 10 15-30

-20

-10

0Investment F

5 10 15-2

-1.5

-1

-0.5

0

Export D

Risk Perception Shock Capital Requirement Shock Jointly

5 10 15

-3

-2

-1

0Import D

5 10 15

-6

-4

-2

0Inflation D

5 10 15

-0.6

-0.4

-0.2

0

0.2Inflation F

5 10 150

2

4

Net Interbank loans

5 10 15-0.4

-0.2

0

Capital Return D

5 10 15

-0.2

0

0.2

Capital Return F

5 10 15

-0.3

-0.2

-0.1

0Real Wage D

5 10 15-0.6

-0.4

-0.2

0Real Wage F

5 10 15-0.5

-0.4

-0.3

-0.2

-0.1

Policy Rate

5 10 150

2

4

6

Deposit Rate D

5 10 15-0.2

-0.1

0

0.1

0.2

Deposit Rate F

5 10 15

0

2

4

6

Mortgage Rate D

5 10 15-0.2

-0.1

0

0.1

0.2

Mortgage Rate F

5 10 15

0

2

4

6

Commercial Loan Rate D

5 10 15-0.2

-0.1

0

0.1

0.2

Commercial Loan Rate F

5 10 150

2

4

6

Bond Rate D

Risk Perception Shock Capital Requirement Shock Jointly

5 10 15-0.2

-0.1

0

0.1

0.2

Bond Rate F

5 10 15

-2

-1

0Output EA

5 10 15-1.5

-1

-0.5

0Inflation EA

5 10 15-0.5

-0.4

-0.3

-0.2

-0.1

Policy Rate

5 10 15

-0.2

-0.15

-0.1

-0.05

0House Prices D

5 10 15

-0.4

-0.2

0House Prices F

5 10 15

-0.05

0

0.05

Capital Price D

5 10 15

-0.1

-0.05

0

0.05

0.1Capital Price F

5 10 15

-2

0

2

4x 10-14RER

5 10 15

-0.1

-0.05

0Consumption Savers D

5 10 15

-0.1

-0.05

0Consumption Borrowers D

5 10 15

-0.2

-0.1

0Consumption Savers F

5 10 15

-0.2

-0.1

0Consumption Borrowers F

5 10 15-10

-5

0Labor Savers D

5 10 15

00.5

11.5

2

Labor Borrowers D

5 10 15

-3

-2

-1

0

Labor Savers F

Risk Perception Shock Capital Requirement Shock Jointly

5 10 15

0

0.1

0.2

0.3Labor Borrowers F

5 10 15-0.06

-0.04

-0.02

0

Housing Savers D

5 10 15

0

0.05

0.1Housing Borrowers D

5 10 15-0.1

-0.05

0Housing Savers F

5 10 15-0.01

-0.005

0Housing Borrowers F

5 10 150

10

20

30

Retail Bank Capital D

5 10 150

5

10

Retail Bank Capital F

5 10 15-0.2

0

0.2

0.4

0.6

Retail Bank Assets D

5 10 150

0.05

0.1

0.15

Retail Bank Assets F

5 10 15

-0.15

-0.1

-0.05

0

Retail Bank Liabilities D

5 10 15-0.03

-0.02

-0.01

0

0.01Retail Bank Liabilities F

5 10 15

0

20

40

60

Investment Bank Capital D

5 10 15-15

-10

-5

0

Investment Bank Capital F

5 10 150

5

10

Investment Bank Assets D

5 10 15

-0.6

-0.4

-0.2

0Investment Bank Assets F

5 10 150

2

4

Investment Bank Liabilities D

Risk Perception Shock Capital Requirement Shock Jointly

5 10 15

-0.3

-0.2

-0.1

0Investment Bank Liabilities F

5 10 15-10

-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15

-8-6-4-20

Output D

5 10 15

-0.2

-0.1

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15-8-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

00.050.1

0.15

5 10 15-10

-5

5 10 15

-1-0.5

0

5 10 15

-0.1

-0.05

0

5 10 15-6-4-202

5 10 15

-1-0.5

0

5 10 15-2

-1

0

5 10 15-0.1

-0.050

0.05

5 10 15-0.1

-0.08-0.06-0.04-0.02

5 10 15

-2

-1

0

5 10 15

-0.020

0.020.04

5 10 15-10

-5

0

5 10 15-4

-2

0

5 10 15

-1

-0.5

0

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1-0.5

00.5

5 10 15

-0.05

0

0.05

5 10 15-4-2024

5 10 15-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15

-0.38

-0.36

-0.34

5 10 15-3

-2

-1

5 10 15

-0.035-0.03

-0.025-0.02

baseline calibration Adding credit gap in the Taylor rule

5 10 15-15-10-50

5 10 15-3

-2

-1

0

5 10 15

-4

-2

Capitalrequirment

RiskPerception

Bankdefault

Commercialdefault

Householddefault

5 10 15-10

-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15

-0.2

-0.1

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

00.050.1

5 10 15-10

-5

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15-6-4-20

5 10 15

-1

-0.5

0

5 10 15-2

-1

0

5 10 15-0.1

-0.050

0.05

5 10 15-0.1

-0.05

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.04

5 10 15-8-6-4-20

5 10 15-4

-2

0

5 10 15-1.2

-1-0.8-0.6-0.4-0.2

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15

-0.1

-0.05

5 10 15-4-202

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15

-0.38

-0.37

5 10 15-3

-2

-1

5 10 15

-0.035

-0.03

-0.025

baseline calibration Countercyclical buffer on retail banks

5 10 15

-10

-5

0

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15

-4

-2

Capitalrequirment

RiskPerception

Bankdefault

Commercialdefault

Householddefault

5 10 15-10

-5Mortgages D

5 10 15-0.6-0.4-0.2

00.2

Commercial Loans D

5 10 15-8-6-4-20

Output D

5 10 15-0.25-0.2

-0.15-0.1

Consumption D

5 10 15-30-20-10

010Investment D

5 10 15

-6-4-20Export D

5 10 15-15

-10

-5

0Inflation D

5 10 15

0

0.05

0.1

5 10 15-10

-5

5 10 15

-1

-0.5

0

5 10 15-0.12-0.1

-0.08-0.06-0.04-0.02

5 10 15-6-4-20

5 10 15

-1

-0.5

0

5 10 15-2

-1

0

5 10 15-0.1

-0.050

0.05

5 10 15-0.1

-0.08-0.06-0.04-0.02

5 10 15

-2-1.5

-1-0.5

5 10 15-0.02

00.020.04

5 10 15-8-6-4-20

5 10 15-4

-2

0

5 10 15-1.2

-1-0.8-0.6-0.4-0.2

5 10 15

-8

-6

-4

5 10 15-10

-8

-6

5 10 15

-1

-0.5

0

5 10 15-0.08-0.06-0.04-0.02

5 10 15-4

-2

0

2

5 10 15

-1

-0.5

0

5 10 15

-2

-1

0

5 10 15

-0.1

-0.05

5 10 15-0.39

-0.38

-0.37

5 10 15-3

-2

-1

5 10 15-0.035

-0.03

-0.025

baseline calibration Countercyclical buffer on investment banks

5 10 15

-10

-5

0

5 10 15-2.5

-2-1.5

-1-0.5

5 10 15

-4

-2

Commercialdefault

Householddefault

Bankdefault

RiskPerception

Capitalrequirment