Macroeconomic implications of "Deep habits" in banking

Abstract

Recent empirical evidence shows that price-cost margins in the market for bank credit are countercyclical in the U.S. economy and that this cyclical behavior can be explained in part from the fact that switching banks is costly for customers (i.e., from a borrower hold-up effect). Our goal, in this paper, is to study the "financial accelerator" role of these countercyclical margins as a propagation mechanism of macroeconomic shocks. To do so, we apply the "deep habits" framework in Ravn, Schmitt-Grohé, and Uribe (2006) to financial markets to model this hold-up effect within a monopolistically competitive banking industry. We are able to reproduce the pattern of price-cost margins observed in the data, and to show that the real effects of aggregate total factor productivity shocks are larger the stronger the friction implied by borrower hold-up. Also, output, investment, and employment all become more volatile than in a standard model with constant margins in credit markets. An empirical contribution of our work is to provide structural estimates of the deep habits parameters for financial markets. © 2010 The Ohio State University.