Integrating explicit financial institutions into dynamic stochastic general equilibrium models

Many commentators have criticized macroeconomists for failing to understand the fragility of the financial system and to provide adequate warning of the risk of crisis and recession in advance of the events that unfolded from the summer of 2007 onwards. Some have blamed DSGE models in particular for misdirecting macroeconomists’ attention (see Buiter, 2009, and Krugman, 2009). While some critics suggest to drop the DSGE approach altogether and restart macroeconomic modelling from scratch, others aim to equip DSGE models with more appropriate financial sectors. The latter objective is pursued in this work package. The planned research effort takes into account that disruptions in financial markets and impairment of financial intermediation can have considerable effects on both the dynamics of the business cycle and on the underlying growth path. During the financial crisis, there was a large build-up of leverage and liquidity dry-ups across the global financial system. The financial system appeared to be inherently fragile, as well as vulnerable to adverse changes in the macroeconomic environment. Projects in this work package explicitly model financial institutions and their risk-taking behaviour and not just add them on to the existing models. They take into account banks’ portfolio decisions, systemic risk, the possibility of sudden interbank market freezes and the risk of default. In doing so, new methodologies are developed to deal with heterogeneous banks, occasionally binding constraints due to capital or liquidity requirements and the transition from normal to crisis regimes.

Dissemination; Other Papers

  1. Explaining International Business Cycle Synchronization: Recursive Preferences and the Terms of Trade Channel.
    Robert Kollmann, Université Libre de Bruxelles and CEPR.
  2. Risk sharing in a world economy with uncertainty shocks.
    Robert Kollmann, Université Libre de Bruxelles and CEPR.
  3. Blanchard and Kahn’s (1980) solution for a linear rational expectations model with one state variable and one jump variable: the correct formula.
    Robert Kollmann, ECARES, Université Libre de Bruxelles, Université Paris-Est and CEPR.
    Stefan Zeugner, DG-ECFIN, European Commission.
  4. Discussion of ‘Market Reforms in the Time of Imbalance’ (Matteo Cacciatore, HEC Montréal; Romain Duval, IMF; Guiseppe Fiori, North Carolina State University; Fabio Ghironi, University of Washington)
    Robert Kollmann, ECARES, Université Libre de Bruxelles and CEPR.
    Lukas Vogel,DG-ECFIN, European Commission.




Key Objectives

(O.5.1) Integrate a more realistic financial sector and financial fragility into tractable, quantitative macroeconomic models suitable for practical policy analysis.

(O.5.2) Advance existing model solution techniques by accounting for nonlinearities inherent in financial boom and bust cycles.

(O.5.3) Explore the impact of a variety of policy instruments on the degree of financial distress, systemic crisis and their macroeconomic consequences.


Main participants