In this project, we have developed a macroeconomic model to address the role of banks play in macroeconomic stability. Our contribution consits of the inclusin of two theoretical noverties: 1) We regard banks as money creation institutions which sets in motion an empirically observed pro-cyclical mechanism. During booms, the assets of banks increase in value. This in turn raises the equity ratios of the banks and leads them to expand their loans. In doing so, they create money which further stimulates the economy. The opposite occurs during recessions. 2) We  add a behavioural feature in this model assuming that agents have cognitive limitations preventing them from having rational expectations. Instead, they use simple heuristics in making forecasts.

 

The combination of the behavioural and the money creation features three main findings: high volatility is generated in a) the output gap and b) in the loan supply. We thirdly observe a strong positive correlation between the two.  The origin of this positive correlation is when economic optimism is on the rise, output is booming, and asset prices increase. This improves the equity position of banks holding their risky assets. This leads them to expand loan supply, which in turn stimulates investment and aggregate demand. All this leads to an important business cycle amplification effect produced by banks.

 

The policy implications of these results are different from conventional models. There is a greater responsibility on the central bank using interest rates to ensure stability of the system when there is a banking sector than in its absence. When the central bank finds it difficult to do so (as it is today when the interest rate is close to zero), macroprudential control has to take over as the main instrument to stabilize the banking system and the economy.

 

Our contribution promises fruitful additional insights to how economists and policy makers could understand macroeconomic stability and which policies are best suited to increase resilience. We hope to extend our work with a broader empirical application and case studies.