Financial Cycles with Heterogeneous Intermediaries

Abstract

This paper develops a dynamic macroeconomic model with heterogeneous financial intermediaries and endogenous entry. It features time-varying endogenous macroeconomic risk that arises from the risk-shifting behaviour of the crosssection of financial intermediaries. We show that when interest rates are high, a decrease in interest rates stimulates investment and increases financial stability. In contrast, when interest rates are low, further stimulus can increase aggregate risk while inducing a fall in the risk premium. In this case, there is a trade-off between stimulating the economy and nancial stability.