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An integrated financial amplifier: the role of defaulted loans and occasionally binding constraints in output fluctuations

Publication Year 
JEL Code 
E62 - Fiscal Policy; Public Expenditures, Investment, and Finance; Taxation
F41 - Open Economy Macroeconomics
H62 - Deficit; Surplus
We present a DSGE model for a small euro area economy comprising a banking sector empowered with regulatory capital requirements, defaulted loans and occasionally binding endogenous credit restrictions. Under non-financial shocks no important amplifications arise due to balancing forces: while banks' equity acts as a shock absorber, the observance of regulatory capital requirements acts as a shock amplifier. Under moderately-sized "bad" financial-based shocks defaulted loans increase and banks' value drop. As a result, credit becomes supply constraint for some time, severely amplifying and protracting output downfalls. Endogenous inertia implies a slow recovery in banks' capital and thus an enduring fragility of the banking system. Defaulted loans and credit restrictions are strongly intertwined, since the former severely impact banks' value, hence leveraging the amplification size.
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