UC Riverside

This dissertation investigates the relationship between the mechanism of limited borrowing capacity of financial intermediaries and the equity premium in a production economy. A medium-scale New Keynesian model is proposed, featuring an agency problem between financial intermediaries and their private creditors, and generalized recursive preferences. The model considers not only the linkages between banking frictions with the macroeconomy, but also with financial markets. The findings are that banking frictions associated with the agency problem generate a plausible and novel enhancing mechanism for risk premia. In the benchmark setting, banking frictions increase the level of the equity premium substantially and the model produces a fourfold greater response to shocks compared to the case of no banking frictions. The paper also finds that the interaction between monetary policy and banking frictions plays a crucial role in determining the dynamics of the equity premium.

Recent financial crises show that the housing market, financial markets, and the rest of the economy are closely linked to each other. The present dissertation also examines the impact of credit limit fluctuations on the equity premium through the financial accelerator channel in a production economy. To do so, this chapter introduces the Kiyotaki-Moore (1997) type collateral constraint and Epstein-Zin-Weil preferences into a medium-scale New Keynesian DSGE model with nominal rigidity. My findings are twofold. First, the endogenous fluctuations of credit limit, a key ingredient of the financial accelerator channel, have only minimal effects on the equity premium both quantitatively and qualitatively. Second, liquidity and housing demand shocks that are closely related to credit limit fluctuations also have a very small impact on the equity premium, while technology shocks help generate the observed equity premium.

Also, recent financial crises indicate that a significant decline in house prices can reduce confidence of economic agents and cause bank runs and a fire sale. Accordingly, this dissertation investigates the role of housing on the household’s attitudes toward risk and derives the closed-form expressions for risk aversion with generalized recursive preferences. This chapter finds that including housing in the utility function lowers risk aversion because housing partially absorbs aggregate shocks to consumption and labor.