How Does the Market-Based Intermediary Sector Affect the Business Cycle? A Consideration Based on a DSGE Framework

This study describes the development of a new-Keynesian dynamic stochastic general equilibrium (DSGE) model in which market-based intermediaries or active investors have an interactive relationship with the ultimate borrowers and lenders. The study also seeks to assess the effects of the presence of active investors on the business cycle. The theoretical analysis yields two important propositions related to market-based intermediaries: first, the greater the active investor’s asset size, the higher will be the expected net profits; second, the steeper the yield curve, the greater is the asset size. These propositions together suggest that steeper yield curves will yield higher net profits to active investors. Using the developed model and the U.S. quarterly data for 1990:Q1-2010:Q3, this study performs empirical analyses and thereby empirically proves the above mentioned propositions in the model. Furthermore, the analyses indicate that the active investor sector is not only a source of the business cycle but also a fluctuation amplifier, that active investors might impede the propagation of monetary policy effects, and that although rigorous financial regulation could forestall asset price bubbles, it might not necessarily lead to economic stability. The results of the theoretical as well as empirical analyses indicate that the active investor sector has significant effects on the business cycle, thus supporting the view of Adrian, Moench and Shin [2010b]