Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/80779 
Authors: 
Year of Publication: 
2013
Series/Report no.: 
Bank of Canada Working Paper No. 2013-3
Publisher: 
Bank of Canada, Ottawa
Abstract: 
During the recent financial crisis in the U.S., banks reduced new business lending amidst concerns about borrowers' ability to repay. At the same time, firms facing higher borrowing costs alongside a worsening economic outlook reduced investment. To explain these aggregate business cycle patterns, I develop a model with households, banks and firms. I assume that a bank's ability to raise deposits is constrained by a limited commitment problem and that, furthermore, loans to firms involve default risk. In this environment, changes in loan rates affect the size of the business sector. I explore how banks influence the behavior of households and firms and find that both productivity and financial shocks lead to counter-cyclical default and interest rate spreads. I examine the implications of a government capital injection designed to mitigate the effect of negative productivity and financial shocks in the spirit of the Troubled Asset Relief Program (TARP). I find that the stabilizing effect of such policy interventions hinges on the source of the shock. In particular, a capital injection is less effective against aggregate productivity shocks because easing banks' lending stance only weakly stimulates firms' demand for loans when aggregate productivity falls. In contrast, a capital injection can counteract the adverse effect of financial shocks on the supply of loans. Finally, I measure aggregate productivity and financial shocks to evaluate the role of each in the business cycle. I find that the contribution of aggregate productivity shocks in aggregate output and investment is large until mid-2008. Financial shocks explain 65% of the fall in investment and 55% of the fall in output in the first quarter of 2009.
Subjects: 
Business fluctuations and cycles
Economic models
Financial stability
JEL: 
E32
E44
E69
Persistent Identifier of the first edition: 
Document Type: 
Working Paper

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