Essays on financial frictions with an application to the Chinese economy
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This dissertation consists of three chapters related to macroeconomic implications of financial frictions, along with an application of macro-finance models to the Chinese economy. The first two chapters focus on government guarantees on business loans to state-owned enterprises (SOEs), a typical practice of the Chinese government. Chapter 1 embeds partial loan guarantees into the loan contracting problem, built upon the costly state verification framework. A larger degree of guarantees dampens the sensitivity of the loan rate to a change in leverage, which incentivizes entrepreneurs to lever up. Also, greater guarantees reduce entrepreneurs' exposures to credit risks, hence altering their choices of investment and leverage in response to an exogenous risk shock. Chapter 2 proceeds to develop a New Keynesian dynamic stochastic general equilibrium (DSGE) model and investigates the effect of government guarantees on capital misallocation and business cycle fluctuations in China. On one hand, government guarantees mitigate the influence of the financial accelerator mechanism on investment and production of both SOEs and private-owned enterprises (POEs). On the other hand, by inducing a time-varying dispersion in returns on capital across SOEs and POEs, government guarantees exert a negative impact on the allocative efficiency of resources and thus cause further losses on total factor productivity (TFP) and output during recessions. Quantitative analyses show that partial loan guarantees to SOEs are counterproductive in moderating the reaction of GDP to both risk and technology shocks. Chapter 3 develops a DSGE model with financial constraints on entrepreneurs and banks, featuring a risk-based bank capital requirement, and discusses the role of Basel II in reinforcing procyclical tendencies of the credit market and the real economy. I study impulse responses of the calibrated model to various shocks. Quantitative results show that the direction and magnitude of cyclical effects arising from Basel II strongly depend on the nature of macroeconomic shocks that hit the economy: only a risk shock can generate noticeable procyclical effect, while the procyclicality under a TFP shock and the countercyclicality under a shock to the marginal efficiency of investment (MEI) are quantitatively insignificant.