Taking Banks to Solow

Abstract

We develop a simple integration of banks into the Solow model. The objective is to provide a tractable benchmark for analyzing the long-term impact of crises on economic activities and growth. A fraction of firms have to rely on banks for financing their investments, while banks themselves face an endogenous leverage constraint. Informed lending by banks and uninformed lending through capital markets spur capital accumulation. The ensuing coupled accumulation rules for household wealth and bank equity yield a uniquely determined steady state. We highlight three properties when shocks to wealth, productivity or trust affect the economy. First, typically, bond and loan financing react in opposite directions to such shocks. Second, negative temporary shocks to household wealth (financial crisis) or negative sectoral production shocks can, surprisingly, cause persistent booms of banking and even of the entire economy – after an initial bust. Third, shocks to bank equity (banking crisis), however, lead to large and persistent downturns associated with high output losses.