An asymmetric country model with financial frictions

Abstract

This thesis inquires into the role of financial factors underlying domestic and cross-border business cycles in a New Keynesian Dynamic Stochastic General Equilibrium framework of two asymmetric countries.

In the first paper, I develop a two asymmetric-country business cycle model in which independent banking sectors are subject to asset diversion. In particular, domestic bankers are able to divert funds away from the interests of shareholders due to the presence of a moral hazard problem. The model allows for an incentive compatibility constraint on a portfolio of loans as well as financial frictions on cross-border lending and the presence of exogenous entrepreneurial net worth. Using a Bayesian likelihood approach, I estimate the model with Australian and U.S. macroeconomic and financial data. I demonstrate that a two asymmetric-country model is able to fit the standard macroeconomic and financial data very well, if one allows for financial frictions on a sufficiently diverse portfolio of loans. Moreover, the model with a full incentive compatibility constraint outperforms its less constrained variants and the pure trade open economy model in reproducing the cross-border synchronization of business cycles. Also consistent with this model, I find that within-country financial shocks are responsible for a substantial portion of business cycle fluctuations in each country and foreign financial shocks play a non-negligible role in cross-border spillovers.

In the second paper, I compare the role of financial friction approaches in a two asymmetric-country model that provides a microfounded rationale for across-country business cycle analysis. To do so, I firstly develop a two asymmetric-country business cycle model without financial frictions - the pure trade open economy model - and then incorporate two financial friction approaches: A costly verification problem whereby bankers pay some cost to verify the outcome of entrepreneurial projects, and a moral hazard problem by which bankers divert some assets from the interests of shareholders. The models are brought to the empirical investigation using Bayesian methods and Australian and U.S. macroeconomic and financial data. Taking the pure trade open economy model as a benchmark, I evaluate the performance of model extensions with financial frictions and the role of each type of financial friction. I find that the presence of financial frictions improves the fit of the pure trade open economy model. The friction model versions also overcome the shortcoming of the pure trade open economy model in reproducing the business cycle synchronization. In addition, the empirical evidence favors the model version with financial frictions in the banking sector.

The third paper evaluates a combination of two financial friction approaches, again in a two asymmetric-country framework. I develop a business cycle model that features leverage constraints on both entrepreneurial and banking balance sheets. The model allows for financial frictions on a diverse portfolio of loans as well as financial frictions on cross-border lending and the presence of important features of the open economy. The role of financial friction types is investigated by comparing models, in which neither, one or both types are turned off. The models are estimated with Bayesian techniques using macroeconomic and financial data for Australia and the U.S. The analysis shows that the two combined financial friction approaches are useful for characterizing country-specific business cycles. In addition, the simultaneous presence of two types of financial frictions amplifies the response of the spreads and the overall economy to financial shocks as compared to the model with either one of two approaches. Indeed, the additional amplification provided by a double financial accelerator effect enhances the model's ability to match the empirically observed volatility of the spreads, investment and other variables.