Costly default and skewed business cycles.

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From: European Economic Review(Vol. 132)
Publisher: Elsevier Science Publishers
Document Type: Report; Brief article
Length: 333 words

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Keywords Real Business Cycle model; Default; Financial frictions; Asymmetry; Optimal regulation Abstract We augment a simple Real Business Cycle model with financial intermediaries that may default on their liabilities and a financial friction generating social costs of default. We derive a closed-form solution for the general equilibrium of the economy, providing analytical results. Endogenous default generates a negative skew for aggregate variables and a positive skew for credit spreads, as documented in the empirical literature. Larger financial frictions strengthen asymmetry, which amplifies the welfare cost of fluctuations. Macro-prudential regulation alleviates both the cost of fluctuations and business-cycle asymmetry, at the expense of a steady-state distortion. Finally, we prove analytically the existence of an optimal level of regulation, which increases with the size of the financial friction. Author Affiliation: (a) Toulouse School of Economics (TSE) and Université Toulouse 1 - Capitole, 21 allée de Brienne, Toulouse 31000, France (b) Banque centrale du Luxembourg (BCL), Département Économie et Recherche, 2 boulevard Royal, L-2983, Luxembourg * Corresponding author. Article History: Received 2 July 2020; Revised 10 November 2020; Accepted 10 December 2020 (footnote)[white star] We thank Florin Bilbiie (the editor), one anonymous co-editor, and two anonymous referees for very useful comments and suggestions. We also benefited from discussions with Philippe Aghion, Nuno Coimbra, Fabrice Collard, Martial Dupaigne, Paolo Fegatelli, Jean-Pierre Florens, William Fox, Paolo Guarda, Alexander Guembel, Christian Hellwig, Nour Meddahi, Kjetil Storesletten, Emmanuel Thibault, Liliana Varela, and Stéphane Villeneuve. Patrick Fève acknowledges funding from the French National Research Agency (ANR) under the Investments for the Future (Investissements d'Avenir) program, grant ANR-17-EURE-0010. This paper has been produced in the context of the partnership agreement between the BCL and TSE. It should not be reported as representing the views of the BCL or the Eurosystem. The views expressed are those of the authors and may not be shared by other research staff or policymakers at BCL or the Eurosystem. Byline: Patrick Fève [patrick.feve@tse-fr.eu] (*,a), Pablo Garcia Sanchez [pablo.garciasanchez@bcl.lu] (b), Alban Moura [alban.moura@bcl.lu] (b), Olivier Pierrard [olivier.pierrard@bcl.lu] (b)

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Gale Document Number: GALE|A650433255