Presented at part of the ADEMU Project at the Macroeconomic and Financial Imbalances and Spillovers Workshop June 2017

1. FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND
MACROECONOMIC INTERDEPENDENCE
Galip Kemal Özhan
University of St Andrews
June 8, 2017
Barcelona GSE Summer Forum
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 1

2. INTRODUCTION
Table: Domestic credit outstanding at the end of the period - per GDP
Germany Ireland Spain Portugal
2000 106 100 87 110
2004 101 126 111 124
2008 95 202 171 151
Source: Giavazzi and Spaventa (2010)
Current account imbalances
Sectoral unit labor costs
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 2

3. CURRENT ACCOUNT AND ALLOCATION OF CREDIT
Longer series
Source: Eurostat and Bank of Spain. Notes: Tradables include industry (excluding construction), agriculture, and fisheries. Non-tradables
include construction and services.
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 3

4. SHARES OF SECTORS IN OVERALL GVA
Longer series
Source: Eurostat. Notes: Non-tradables include construction, wholesale and retail trade, transport, accommodation, food service and real
estate activities. Tradables include industry (excl. const.), agriculture, forestry and fishing.
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 4

5. INTERPRETATIONS
Optimism about the future state of the economy (Blanchard, 2006,
Blanchard and Giavazzi, 2002, Constâncio, 2005)
I Investment and output boom
I Large current account deficits financed by bank lending
Increase in the value of non-financials starting from 1998 (Bris,
Koskinen, and Nilsson, 2009, 2012)
The Global Financial Crisis raised suspicions (Eichengreen, 2010,
Giavazzi and Spaventa, 2010, Merler and Pisani-Ferry, 2012)
I Capital flow reversals, collapse of bank lending and output
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 5

6. QUESTIONS
What is the role of the financial sector in affecting domestic resource
allocation and cross-border capital flows?
Does domestic allocation of foreign borrowing matter for the current
account?
What are the implications of unconventional policy when the economy is
suffering from sudden reversals of capital flows?
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 6

7. WHAT I DO (1)
Developing a two-country quantitative macro model with a financial
sector, in which intermediaries lend funds to be invested in traded or
non-traded sector capital, and borrow from households in both countries
I Distinguishing between goods produced in each country
I Incomplete international financial markets (deposits)
I Asset heterogeneity within an economy
I Occasionally binding endogenous leverage constraints
(Benigno and Thoenissen, 2008, Corsetti, Dedola, and Leduc, 2008, Gertler
and Karadi, 2011, Gertler and Kiyotaki, 2010)
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 7

8. WHAT I DO (2)
Conducting experiments when agents are optimistic about future value of
capital and capturing non-traded-sector-led boom-bust cycles (similar to
formulation in Beaudry and Portier, 2006, Christiano et al., 2010)
I Anticipations about higher value of assets (capital): Borrowing and credit
expansion
I News turn out to be incorrect: Collapse in investment, bank lending,
output; jump in credit spreads
Fluctuations based solely on optimism and disappointment (Pigou, 1927,
Keynes, 1936; Abreu and Brunnermeier, 2012, Brunnermeier and
Oehmke, 2013)
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 8

9. WHAT I DO (3)
Studying unconventional monetary policy (UMP) conducted by a
common central bank: Direct asset purchases and liquidity facilities
I In response to unfulfilled expectations
I Toward sector-specific conditions
I Funded by interest-bearing reserves
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 9

10. NEW INSIGHTS
Model’s non-linear solution that captures the state dependent fluctuations is
crucial for explaining the consensus narrative. When leverage constraints
bind:
Stronger financial accelerator: demand channel
Bank portfolio problem: intra-national spillover channel
International incomplete markets: international spillover channel
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 10

11. NEW INSIGHTS
Model’s non-linear solution that captures the state dependent fluctuations is
crucial for explaining the consensus narrative. When leverage constraints
bind:
Stronger financial accelerator: demand channel
Bank portfolio problem: intra-national spillover channel
International incomplete markets: international spillover channel
UMPs in response to unfulfilled news are successful at preventing output to
fall further
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 10

12. PREVIEW OF THE MODEL OUTCOME
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 11

13. PREVIEW OF THE MODEL OUTCOME (CONT’D)
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14. THE MODEL
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15. HOUSEHOLDS
g fraction of household members are bankers, 1 g are workers
Workers and bankers bring their wages and profits to their household
Perfect consumption insurance within households
To limit the bankers’ ability to overcome financial constraints:
I with probability 1 , bankers switch occupation every period
I new bankers receive start-up funds from their household
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 14

16. HOUSEHOLDS
Expected intertemporal utility:
E0
1X
t=0
t
2666664
C
1 ⇢
t
1 ⇢
$*.
,
L
1+'1
T,t
1+ '1
+
L
1+'2
NT,t
1+ '2
+/
-
3777775
Consumption baskets:
Ct =

a
1

T
C
( 1)

T,t
+ (1 aT )
1
 C
( 1)

NT,t

 1
CT,t =

a
1
!
H
C
(! 1)
!
H,t
+ (1 aH )
1
! C
(! 1)
!
F,t
!
! 1
Budget constraint:
Ct +Bt+1 + ⇠tB⇤,t+1 + ⌘
2 ⇠t (B⇤,t+1)2
= (1+rt )Bt + (1+r⇤
t )⇠tB⇤,t +wT,tLT,t +wNT,tLN,t +⇧t +Tf ⇤
t +Tt
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 15

17. FIRMS
Goods producers:
Yi,t = eai,t
(e i,t
Ki,t )↵
Li,t
1 ↵
Expected discounted profits:
Et
P1
s=t
s⇤s,s+1[RPii,s+1Yi,s+1 +Qi,s+1(1 )e is+1 Ki,s+1
wi,s+1Li,s+1 (1+rk,i,s+1)Qi,sKi,s+1]
FOCs:
Et [⇤t,t+1 1+ri,k,t+1 ] = Et
2666664
⇤t,t+1
*.
,
RPii,t+1↵
Yi,t+1
Ki,t+1
+ (1 )e i,t+1 Qi,t+1
Qi,t
+/
-
3777775
RPii,t+1(1 ↵)
Yi,t+1
Li,t+1
= wi,t+1,
where ⇤t,t+1 = UC (t+1)
UC (t) , and i 2 {T,NT } and ii 2 {H,NT }.
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18. FIRMS
Capital producers:
Objective:
MaxIi,t Qi,tKi,t+1 Qi,t (1 )e i,t
Ki,t Ii,t
Constraint:
Ki,t+1 = (1 )e i,t
Ki,t +Ii,t f
Ii,t
e i,t Ki,t
!
e i,t
Ki,t
Q relation for investment:
Qi,t =
1
1 fI
✓
Ii,t
e i,t Ki,t
◆
e i,t Ki,t
(Bocola, 2015 and Mimir, 2015)
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 17

19. FINANCIAL INTERMEDIARIES
Balance sheet:
QT,tST,t (j) +QNT,tSNT,t (j) = Bt+1(j) +B⇤
t+1(j) +Nt (j) (1)
Evolution of net worth:
Nt+1(j) = (1+rk,T,t+1)QT,tST,t (j) + (1+rk,NT,t+1)QNT,tSNT,t (j)
(1+rt+1)(Bt+1(j) +B⇤
t+1(j))
(2)
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 18

20. FINANCIAL INTERMEDIARIES
Expected discounted value at the time:
MaxSi,t,Bt+1,B⇤
t+1
Vt (j) = Et ⇤t,t+1 [(1 )Nt+1(j) + V t+1(j)]
s.to (1), (2), and (IC)
Incentive constraint (IC):
V t (j) T QT,tST,t (j) + NT QNT,tSNT,t (j)
where ⇤t,t+1 = UC (t+1)
UC (t) .
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21. FINANCIAL INTERMEDIARIES
Guess and verify: Vt (j) = ⌫tNj,t
FOCs:
Et [⇤t,t+1⌦t+1(rk,T,t+1 rt+1)] = µt T
Et [⇤t,t+1⌦t+1(rk,NT,t+1 rt+1)] = µt NT
where ⌦t ⌘ [(1 ) + ⌫t]
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 20

22. FINANCIAL INTERMEDIARIES
µt = max
(
1
Et [⇤t,t+1⌦t+1(1+rt+1)Nt]
T QT,tST,t + NT QNT,tSNT,t
!
,0
)
With µt = 0 8t, banking is frictionless and ⌦t = 1
With µt > 0, IC is binding and the cost of capital is higher than in the
frictionless case
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 21

23. FINANCIAL INTERMEDIARIES
The IC places a restriction on the size of the bank’s portfolio relative to its net
worth:
QT,tST,t (j) + NT
T
QNT,tSNT,t (j)
Nt (j)

⌫t
T
Bank leverage is constrained at the point where the gain from running away
with assets is balanced with the cost of default
Aggregation
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 22

24. BELIEF-DRIVEN DYNAMICS
The shock specification assumes an anticipated (uA
i,t n) and an unanticipated
component (uU
i,t ):
i,t = ⇢ i,t 1 +uA
i,t n +uU
i,t
If uU
i,t = uA
i,t n at t = n, then anticipations are not realized
(Beaudry and Portier, 2006, Christiano et al. 2010)
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 23

25. CALIBRATION
Parameter Value Comments
Discount factor 0.995 Standard RBC value
Risk aversion coefficient ⇢ 2 Standard RBC value
Relative weight of labor $ 5.584 Gertler and Kiyotaki (2010)
Frisch elasticity (T Sector) '1 0.276 Gertler and Karadi (2011)
Frisch elasticity (NT Sector) '2 0.276 Gertler and Karadi (2011)
Deposit adjustment ⌘ 0.025 Standard RBC value
Elasticity of substitution between Home and Foreign goods ! 1.2 Standard RBC value
Elasticity of substitution between traded and non-traded goods  1 Drozd and Nosal (2010)
Investment adjustment 'K 5 BGG (1999)
Depreciation 0.025 Standard RBC values
Home bias aH 0.55 To match the data
Share of tradable sector aT 0.55 To match the data
Share of capital in production ↵ 0.333 Standard RBC value
Exit probability of banks 0.975 Bank survival of 10-years
Fraction of start-up funds " 0.0001 To min the effect of bank entry
T sector moral hazard T 0.4126 Steady state excess return
in NT sector of 50bps,
NT sector moral hazard NT 0.2063 in T sector of 100bps
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 24

26. CALIBRATION (CONT’D)
Adjust the expected valuation in assets to match the cumulative banking
exposure to traded and non-traded sectors between 1999:QIV-2008:QI
Adjustment implies a 25.5% expected valuation in NT assets (with a 0.55
correlation with T assets)
Qualitative results not dependent on this specific calibration
Steady state leverage
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27. MODEL PERFORMANCE
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28. MODEL PERFORMANCE (CONT’D)
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29. THREE MODEL VERSIONS
No banking, under financial autarky
RPH,tC⇤
H,t =
RPF,t
⇠t
CF,t
Domestic banking, under financial autarky
QT,tST,t (j) +QNT,tSNT,t (j) = Bt+1(j) +Nt (j)
RPH,tC⇤
H,t =
RPF,t
⇠t
CF,t
International deposit market integration
QT,tST,t (j) +QNT,tSNT,t (j) = Bt+1(j) +B⇤
t+1(j) +Nt (j)
CAt = ⇠t B⇤,t+1 B⇤,t
⇣
B⇤
t+1 B⇤
t
⌘
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 28

30. INSPECTING THE MECHANISM (1)
Key mechanism:
QT,tST,t +
NT
T
QNT,tSNT,t =
⌫t
T
Nt
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 29

31. INSPECTING THE MECHANISM (2)
Linear vs Non-linear Wage differentials Percent contributions
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32. INSPECTING THE MECHANISM (3)
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33. UNCONVENTIONAL MONETARY POLICY
ECB used its powers as a lender of last resort in reaction to the crisis
I Conducted twenty LTROs with three and six month maturity between
April 2008 and October 2011
I Additional program of outright purchases of asset-backed-securities on
November 21, 2014
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 32

34. UNCONVENTIONAL MONETARY POLICY
ECB used its powers as a lender of last resort in reaction to the crisis
I Conducted twenty LTROs with three and six month maturity between
April 2008 and October 2011
I Additional program of outright purchases of asset-backed-securities on
November 21, 2014
UMP substitutes central bank intermediation for private bank
intermediation
I Central bank is more efficient in raising funds: Barro-Sargent-Wallace
Irrelevance Proposition
CB issues debt to banks to fund the UMP: Interest-bearing reserves
Eurosystem balance sheet
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 32

35. PRIVATE ASSET PURCHASES
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36. PRIVATE ASSET PURCHASES
CB balance sheet:
QT,tSg
T,t
+QNT,tSg
NT,t
= Bg
t + ⇠tB⇤g
⇤,t
where Sg
T,t
= 'ump
T,t
ST,t, and Sg
NT,t
= 'ump
NT,t
SNT,t
Rule: ˆ'ump
NT,t
= ⇢'
ump
NT
ˆ'ump
NT,t 1
+uump
NT,t
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 34

37. PRIVATE ASSET PURCHASES (CONT’D)
Bank balance sheets:
QT,tSp
T,t
(j) +QNT,tSp
NT,t
(j)
| {z }
Private Assets
+ Bg
t (j)
|{z}
Interest-Bearing Claims
= Bt+1(j) +B⇤
t+1(j) +Nt (j)
IC:
Vt (Nt (j)) T QT,tST,t (j) + NT QNT,tSNT,t (j) + ECBBg
t (j)
UMP friction does not apply to Foreign banks: Home may exit the EZ
and Home banks divert assets in that case
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 35

38. PRIVATE ASSET PURCHASES (CONT’D)
Private asset purchases relax bank balance sheet constraints:
µt = max
8><
>
:
1 *
,
Et [⇤t,t+1⌦t+1(1+rt+1)Nt]
T QT,tSp
T,t
+ NT QNT,tSp
NT,t
+ ECBBg
t
+
-
,0
9>=
>
;
If the constraint is not binding, CB purchases are neutral, and therefore
inefficient
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39. LIQUIDITY FACILITIES
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 37

40. LIQUIDITY FACILITIES
Bank balance sheets:
QT,tST,t (j) +QNT,tSNT,t (j) +B
g
t (j) = Bt+1(j) +B⇤
t+1(j) + Mt+1(j)
| {z }
Discount Window Lending
+Nt (j)
IC:
Vt (Nt (j)) T QT,tST,t (j)+ NT (QNT,tSNT,t (j) Mt+1)+ ECB (B
g
t (j) Mt+1(j))
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 38

41. LIQUIDITY FACILITIES (CONT’D)
Liquidity injections relax bank balance sheet constraints:
µt = max
(
1
Et [⇤t,t+1⌦t+1(1+rt+1)Nt]
T QT,tST,t + NT QNT,tSNT,t + ECBBg
t ( ECB + NT )Mt+1
!
,0
)
Mt+1: Central bank loans that are carried into t +1
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 39

42. MODEL PERFORMANCE UNDER UMPS
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43. MODEL PERFORMANCE UNDER UMPS (CONT’D)
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44. UMP COMPARISON
Relaxation of binding constraints (AP)
Relaxation of binding constraints (LF)
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45. CONCLUSIONS
The model is successful at producing a boom-bust cycle that is
reminiscent of the recent situations in Spain
Three main channels in explaining the mechanism:
I Demand Channel
I Bank Spillover Channel
I International Deposit Market Channel
ECB-type UMP is successful at mitigating the fall in bank lending and
output
A rigorous treatment of the consensus view of what caused the EZ Crisis
(Baldwin and Giavazzi (2015))
I “Capital flows fed non-traded portion of the economy, and the effects of
sudden-reversals were amplified due to bank dominance”
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 43

46. CURRENT ACCOUNT IMBALANCES: CORE VS PERIPHERY
(BN USD)
Source: IMF World Economic Outlook, October 2015. Notes: Core includes Austria, Finland, Germany,
and the Netherlands. Periphery includes Greece, Italy, Portugal, Spain, and Ireland.
Back
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 44

47. SECTORAL UNIT LABOR COSTS: LOG DIFFERENCES
2000-08
Source: IMF World Economic Outlook
Back
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 45

48. CURRENT ACCOUNT AND THE ALLOCATION OF CREDIT
Back
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49. SHARES OF SECTORS IN OVERALL GVA
Back
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50. FINANCIAL INTERMEDIARIES
Aggregation:
Nt = Nx,t +Nn,t
with
Nx,t = [(1+rk,T,t )QT,t 1ST,t 1 + (1+rk,NT,t )QNT,t 1SNT,t 1
(1+rt )(Bt +B⇤
t )],
Nn,t = "(1 )[(1+rk,T,t )QT,t 1ST,t 1
+(1+rk,NT,t )QNT,t 1SNT,t 1]
Back
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 48

51. STEADY-STATE LEVERAGE
Back
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52. THE ROLE OF OCCASIONALLY BINDING CONSTRAINTS
Back
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53. WAGE DIFFERENTIALS
Back
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54. % CONTRIBUTIONS
Boom Regime
YT YNT
Barebone 45.4% 88.8%
+Banking 8.7% 1.9%
+Int fin markets 45.8% 9.2%
Bust Regime
YT YNT
Barebone 10.1% 68%
+Banking 52.9% 13%
+Int fin markets 36.9% 18.9%
Back
GALIP KEMAL OZHAN FINANCIAL INTERMEDIATION, RESOURCE ALLOCATION, AND MACRO INTERDEPENDENCE 52

55. EUROSYSTEM LIABILITIES
Source: European Central Bank
Back
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