A Tail of Three Occasionally Binding Constraints: A Modelling Approach to GDP-at-Risk

David Aikman; Kristina  Bluwstein; Sudipto  Karmakar

doi:10.1057/s41308-024-00253-y

A Tail of Three Occasionally Binding Constraints: A Modelling Approach to GDP-at-Risk

David Aikman, Kristina Bluwstein, Sudipto Karmakar

Banking & Finance

BANK OF ENGLAND

Research output: Contribution to journal › Article › peer-review

Abstract

We build a semi-structural New Keynesian model to study the drivers of macroeconomic tail risk (‘GDP-at-Risk’). Our model features three key nonlinearities: an effective lower bound on nominal interest rates; a credit crunch in bank loan supply when bank capital depletes; and deleveraging by borrowers when debt service burdens become excessive. These nonlinearities can interact to amplify GDP-at-Risk: for example, when debt burdens rise sufficiently, this increases the risk of debt deleveraging but also that of a credit crunch and hitting the effective lower bound. We use the model to study various UK recessions and document the amplification potential driven by the prevailing levels of headroom vis-a-vis the effective lower bound, the bank capital constraint, and the debt service burden threshold. Furthermore, we simulate a persistent inflation shock to analyse how these interactions might operate at this juncture.

Original language	English
Journal	IMF Economic Review
DOIs	https://doi.org/10.1057/s41308-024-00253-y
Publication status	Published - 9 Aug 2024

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abstract = "We build a semi-structural New Keynesian model to study the drivers of macroeconomic tail risk ({\textquoteleft}GDP-at-Risk{\textquoteright}). Our model features three key nonlinearities: an effective lower bound on nominal interest rates; a credit crunch in bank loan supply when bank capital depletes; and deleveraging by borrowers when debt service burdens become excessive. These nonlinearities can interact to amplify GDP-at-Risk: for example, when debt burdens rise sufficiently, this increases the risk of debt deleveraging but also that of a credit crunch and hitting the effective lower bound. We use the model to study various UK recessions and document the amplification potential driven by the prevailing levels of headroom vis-a-vis the effective lower bound, the bank capital constraint, and the debt service burden threshold. Furthermore, we simulate a persistent inflation shock to analyse how these interactions might operate at this juncture.",

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N2 - We build a semi-structural New Keynesian model to study the drivers of macroeconomic tail risk (‘GDP-at-Risk’). Our model features three key nonlinearities: an effective lower bound on nominal interest rates; a credit crunch in bank loan supply when bank capital depletes; and deleveraging by borrowers when debt service burdens become excessive. These nonlinearities can interact to amplify GDP-at-Risk: for example, when debt burdens rise sufficiently, this increases the risk of debt deleveraging but also that of a credit crunch and hitting the effective lower bound. We use the model to study various UK recessions and document the amplification potential driven by the prevailing levels of headroom vis-a-vis the effective lower bound, the bank capital constraint, and the debt service burden threshold. Furthermore, we simulate a persistent inflation shock to analyse how these interactions might operate at this juncture.

AB - We build a semi-structural New Keynesian model to study the drivers of macroeconomic tail risk (‘GDP-at-Risk’). Our model features three key nonlinearities: an effective lower bound on nominal interest rates; a credit crunch in bank loan supply when bank capital depletes; and deleveraging by borrowers when debt service burdens become excessive. These nonlinearities can interact to amplify GDP-at-Risk: for example, when debt burdens rise sufficiently, this increases the risk of debt deleveraging but also that of a credit crunch and hitting the effective lower bound. We use the model to study various UK recessions and document the amplification potential driven by the prevailing levels of headroom vis-a-vis the effective lower bound, the bank capital constraint, and the debt service burden threshold. Furthermore, we simulate a persistent inflation shock to analyse how these interactions might operate at this juncture.

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M3 - Article

SN - 2041-4161

JO - IMF Economic Review

JF - IMF Economic Review

ER -

A Tail of Three Occasionally Binding Constraints: A Modelling Approach to GDP-at-Risk

Abstract

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