The Effects of Monetary and Fiscal Policy on Financial Instability in Iran through Banks and Entrepreneurs Leverage Behavior: A Dynamic Stochastic General Equilibrium Model

Document Type : Original Article

Authors

1 Shiraz University

2 Department of Economics, Shiraz University

3 Assistant Professor of Economics Department, Faculty of Economics, Management and Social Sciences, Shiraz University, Shiraz, Iran.

10.48308/jem.2024.236064.1923

Abstract

Using a new Keynesian dynamic stochastic general equilibrium (DSGE) framework, the present study takes a novel approach by investigating the effects of monetary and fiscal shocks on macroeconomic dynamics and banks' and entrepreneurs' leverage behavior as key factors contributing to financial instability in Iran from 1990-2022. Our impulse response analysis shows that expansionary monetary and fiscal shocks stimulate economic growth and enhance the risk of financial instability by increasing the leverages of banks and entrepreneurs, widening the spread between loan and deposit rates, and narrowing the spread between entrepreneurial capital returns and loan rates. In other words, we find that banks' and entrepreneurs' leverage behavior is procyclical, creating a trade-off between economic growth and financial instability. Furthermore, the results indicate that the effect of monetary shock on macroeconomic variables, leverages, and spreads is larger than that of fiscal shocks. Given that higher bank and entrepreneur leverages might contribute to financial instability, as a policy recommendation, we suggest simultaneously enhancing stability by employing new complementary measures, such as macroprudential policies.

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