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Friday, June 04, 2010

Woodford: Financial Intermediation and Macroeconomic Analysis

While I'm on the topic of modern macro models, here's a recent paper (May 2010) from Michael Woodford that I came across while running down a reference for the post that follows this on. One of the missing elements in modern models -- a point I've made here often -- is the connection between financial intermediation and the real economy. So it's nice to see Woodford pushing in this direction:

Financial Intermediation and Macroeconomic Analysis, by Michael Woodford, May 2010: How will the financial crisis change the teaching of macroeconomics? While it is difficult to predict intellectual developments before they occur, one can be reasonably confident that the macroeconomic implications of developments in the financial sector will receive a great deal more attention from now on. Of course, issues relating to financial stability have always been part of the curriculum --- though perhaps presented as mainly of historical interest, or primarily of relevance to emerging markets. But recent events have made it clear that financial issues need to be integrated much more thoroughly into the basic framework for macroeconomic analysis with which students are provided.
Why has financial intermediation not played a more central role in the macroeconomic theory of the past few decades? Some suggest that fundamental theoretical or methodological commitments have made it difficult for mainstream macroeconomists to consider hypotheses under which financial conditions can be considered an independent determinant of economic outcomes. But a more straightforward explanation is that financial developments, at least in the U.S., had rendered the kinds of financial constraints previously emphasized in macroeconomic analysis less obviously important.
The Keynesian macroeconomic models of the third quarter of the twentieth century had emphasized the determinants of expenditure flows as the crucial factors behind variations in both economic activity and inflation, and the availability of credit was certainly recognized as among the important determinants of at least some key categories of spending. But the constraints on the availability of credit that were emphasized in models of the time resulted from specific institutional forms and regulatory requirements that came to be of less relevance.
For example, accounts of the “bank lending channel” of the transmission of monetary policy emphasized the indispensable role of traditional commercial banks as sources of credit for certain kinds of borrowers, without direct access to capital markets.1 Deposits were in turn held to be an indispensable source of funding for the lending of commercial banks, and these were subject to legal reserve requirements. To the extent that the latter requirements were typically a binding constraint, a reduction in the supply of reserves by the Fed would require the volume of deposits to be reduced, which would in turn require less lending by commercial banks. Yet the importance of this channel for effects of monetary policy on economic activity depended on the simultaneous validity of each of the links in the proposed mechanism: the reserve requirements a binding constraint for many banks, the lack of sources of funding for commercial banks other than deposits, the lack of sources of credit other than commercial banks for an important subset of borrowers, and the lack of opportunities for banks to substitute between other assets and the kind of lending for which they were essential.
Each of these assumptions was less obviously defensible after the financial innovations and regulatory changes of the 1980s and 1990s.2 Non-bank financial intermediaries became increasingly important as sources of credit, particularly as a result of the growing popularity of securitization. Panel (a) of Figure 1 [here] shows total net lending by the U.S. private financial sector; while commercial banks are clearly still important, they are far from the only important source of credit. More importantly, both the recent lending boom and the more recent financial crisis had more to do with changes in financial flows of several of the other types shown in the figure; for example, lending by ABS issuers surged in the period up until the summer of 2007, and then crashed.
And commercial banks themselves have increasingly turned to sources of funding other than deposits. Panel (b) of Figure 1 [here] shows the net increase in commercial-bank liabilities each quarter from each of several sources. Checkable deposits are only a small part of these institutions’ financing; moreover, deposits shrank during the years of the lending boom, but have risen again during the crisis --- so that neither the growth in commercial-bank assets during the boom nor the contraction of bank assets in 2009 can be attributed to variations in the availability of deposits as a source of financing.
And finally, with the increase in vault cash holdings that has resulted from the spread of ATM machines, reserve requirements have become no longer a binding constraint for many banks (even before the massive increase in the supply of bank reserves during the financial crisis).3 As a consequence, the continuing relevance of the traditional bank lending channel is subject to considerable doubt.
Such developments have made it tempting to abstract from credit frictions in macroeconomic modeling, at least as a first approximation.4 However, the recent financial crisis has made it plain that even in economies like the U.S., with substantially market-based financial systems, significant disruptions of financial intermediation remain a possibility. Understanding such phenomena, and analysis of possible policy responses to them, requires the development of a macroeconomic framework appropriate to a market-based financial system in which credit is nonetheless not a veil.

Fortunately, work on the development of more modern approaches to the introduction of credit frictions into macroeconomic analysis is well underway.5 Here I sketch the basic elements of a modern model, at a level of detail intended to be suitable for presentation in an undergraduate course.6 I begin by explaining the basic analytical framework, and then briefly discuss some of the implications of a model of this kind for monetary policy. ...[continue reading]...

Let me relate this to the post below this one, and adopt a more critical stance toward the existing work on policy multipliers during recessions such as the one we are experiencing. First, on the empirical side, there's the problem of not having very much data to work with. In New Keynesian models, the economy behaves very differently at the zero bound, so data from ordinary times doesn't tell us much. Thus, any estimates of the multipliers that are based upon data from times when the interest rate was above zero, which is most of the evidence that we have, are highly suspect.

Second, and more to the point of this post, with respect to the theoretical models, if we don't have the connections between the financial and real sectors fully modeled -- if important elements of the transmission mechanism for financial and policy shocks are missing -- then I don't know how much faith we can put in the multipliers (or monetary and fiscal policy) that we derive from these models. That's one reason why this new work is important. We don't know for sure that the policy prescriptions that are called for in the existing models will carry over to models that incorporate an explicit role for financial intermediation in supporting real activity. I think the outcome will be much the same in terms of the overall message about stimulating aggregate demand, and that the new models will justify many of the creative steps the Fed took during the crisis. But we can't be sure until we actually build these models and look at the types of polices that work the best within the new framework.

    Posted by on Friday, June 4, 2010 at 12:42 AM in Academic Papers, Economics, Macroeconomics, Methodology | Permalink  Comments (11)


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