Economies of Scale in Banking, Indeterminacy, and Business Cycles.pdf

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Economies of Scale in Banking, Indeterminacy, and Business Cycles.pdf

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Economies of Scale in Banking, Indeterminacy, and Business Cycles

Economies of Scale in Banking, Indeterminacy, and Business Cycles Scott J. Dressler? Villanova University April 2007 Abstract This paper investigates an environment featuring inside money, nominal rigidities and indeterminacy due to increasing returns to scale (IRS) in the financial intermediary. Although the size of the financial intermediary sector is calibrated to be approximately 1-2 percent of value added to output: (i) indeterminacy arises for very small degrees of IRS and standard parameter assumptions; (ii) sunspot shocks have significant effects due to the money multiplier; (iii) idiosyncratic sunspot shocks qualitatively resemble exogenous monetary shocks; and (iv) although endogenous monetary policy can in- crease the degree of IRS needed for indeterminacy, policy can only stabilize sunspot shocks under complete information. Keywords: Financial Intermediation, Inside Money, Indeterminacy, Business Cycles JEL: C68, E32, E44 ?First version: February 2007. Address: Villanova University; 800 Lancaster Avenue; Villanova, PA 19085-1699. Phone: (610) 519-5934. Fax: (610) 519-6054. Email: scott.dressler@villanova.edu. 1. Introduction Business cycle environments focusing on the beliefs of agents (or animal spirits) have become popular tools for analyzing economic fluctuations. Following Farmer (1993), much of the related literature has focused on environments featuring increasing returns to scale (IRS) in production which deliver indeterminate equilibria and allow an analysis of the economic impact of resulting sunspot shocks. While providing a rich environment to analyze the extent through which agents’ beliefs influence business cycle fluctuations, some features of IRS in the production technology are at odds with the empirical facts. For example, the degree of IRS needed to deliver indeterminacy in environments with one sector of production [i.e. Farmer and Guo (1994) and Gali (1994)] far exceeds the constant returns estimated by Basu and Fernald (1997).1 In co