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FINANCIAL NEWS, BANKS, AND BUSINESS CYCLES

Published online by Cambridge University Press:  10 June 2016

Christopher M. Gunn  and
Alok Johri
Christopher M. Gunn*
Affiliation:
Carleton University
Alok Johri
Affiliation:
McMaster University
*
Address correspondence to: Christopher M. Gunn, Department of Economics, 1125 Colonel By Dr., Ottawa, ON K1S 5B6, Canada; e-mail: chris.gunn@carleton.ca.
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Abstract

In a model where banks face a capital sufficiency requirement, we demonstrate that news about a fall in the expected return on a portfolio of international long bonds held by a bank leads to an immediate and persistent fall in economic activity. Even if the news never materializes, economic activity falls below steady state for several periods, followed by a recovery. The portfolio adjustment induced by the capital sufficiency requirements leads to a rise in loan rates and tighter credit conditions, which trigger the fall in activity. We contribute to the news-shock literature by showing that imperfect signals about future financial returns can create business cycles without relying on the usual suspects—shocks to technology, preferences, or fiscal policy—and to the emerging economy business cycle literature in that disturbances in world financial markets can cause domestic business cycles without shocks to the world interest rate or to country spreads.

Keywords

Expectations-Driven Business CyclesFinancial News ShocksFinancial IntermediationBusiness CyclesSmall Open EconomyCapital Adequacy Requirements
Type
Articles
Information
Macroeconomic Dynamics , Volume 22 , Issue 2 , March 2018 , pp. 173 - 198
Copyright
Copyright © Cambridge University Press 2016 

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Footnotes

The authors thank referees and seminar and conference participants at ICRIER, New Delhi, the University of Ottawa, the Conference on Growth and Development, the Asian Meetings of the Econometric Society, and the 2013 meetings of the Society for Computational Economics (CEF 2013). This research was partially supported by a research grant from McMaster University.

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