Is the Financial System Fit for Purpose?
A Behavioural Macroeconomic Model with a Banking Sector
Principal Investigator: Yuemei Ji
Yuemei Ji is a Lecturer in the School of Slavonic and East European Studies (SSEES) at University College London. She completed her undergraduate studies in Economics at Fudan University Shanghai and obtained her PhD in economics from the University of Leuven in 2011. Yuemei Ji’s interests cover three aspects. 1. International macroeconomics in general and the European monetary union during post-crisis period in particular. 2. Behavioural macroeconomics. 3. The Chinese economy, especial its financial development and the government and private debt problems.
Co-Investigators: Professor Paul De Grauwe (John Paulson Chair in European Political Economy, European Institute, London School of Economics).
There is a large gap between the theoretical work in mainstream macroeconomics and the existing empirical findings concerning banks and the economy. Policy discussions from the existing theoretical work are muddled by the existence of two problems.
The first problem is that banks are regarded as financial intermediaries that do not create money. They only collect money from savers and lend it to firms and households. As a result, banks are perceived to play a limited role in generating financial and economic instability.
The second problem is that most of the current models are developed in a framework that assumes rational agents who understand the complexity of the world in which they live, and in particular the nature of the risks.
In this project, we will develop a behavioural macroeconomic model that fundamentally departs from the conventional macroeconomic models. It has two features.
The first feature is that banks are money creation and destruction institutions. When banks extend a new loan they at the same time create a new deposit. As a result, loan supply is not constrained by the total saving of the economy. It will be shown that this adds an important pro-cyclical feature into our model: during a boom when loan demand is high, banks accomodate this higher demand by increasing loan supply and in so doing create more money which in turn tends to intensify the boom. The opposite will be shown to occur during a recession.
The second feature is that we will allow agents to have cognitive limitations in making forecasts. One lesson we have learned from the financial crisis is that this crisis was made possible by the fact that agents do not fully understand the complexity of the world. In our model, we will assume agents use simple rules (heuristics) to guide their behaviour. Agents also evaluate the performance of these rules against alternative rules and they are willing to switch to the better performing one. This modelling approach is based on existing insights from other disciplines such as psychology and brain science.
One important implication of this modeling choice will be that there is heterogeneity among individuals. These individuals do not all use the same rules of behaviour, but they influence each other, and as a result collective waves of “optimism” and “pessimism” can emerge endogenously, driving the business cycle. These endogenous movements have been absent in the mainstream DSGE models.
Our project will generate policy implications concerning banks and macroeconomic stability. In mainstream macroeconomic models, the role of the central bank is a minimalist one: the central bank limits itself to keeping the price level stable and after some exogenous shock to help the market system to smoothly find its equilibrium. We will analyse whether this minimalist view of the central bank’s responsibility is appropriate and whether there is a need to “stabilize an otherwise unstable system”. We will analyse the impact of non-conventional macroprudential policies as well as conventional monetary policies aiming at limiting bank lending.