Essays on macroeconomics of banking and asset bubbles

The dissertation consists of three chapters. In the first chapter, I develop a model to study the production of private safe assets by the banking sector. In response to a shortage of safe assets, the banking sector produces more private safe assets which alleviate the decline of aggregate investment and output. However, producing more private safe assets exposes the bank to more aggregate risk. Macroprudential policies can adjust the production of private safe assets with a tradeoff: encouraging the production of private safe assets alleviates the safe asset shortage problem and improves output, at the cost of a more volatile economy. In the second chapter, I document that during the 2008 financial crisis, U.S. shadow banks deleveraged sharply while commercial banks maintained their leverage. I find that banks that relied more on short-term funding tended to deleverage more during the crisis. I build a model to incorporate both shadow banks and commercial banks with different leverage determination mechanisms. The model can explain the leverage dynamics of the banking sector and the flight-to-quality phenomenon observed in data. The third chapter is coauthored with Jianjun Miao and Pengfei Wang. We revisit Galí’s (2014) analysis by extending his model to incorporate persistent bubble shocks. We find that under adaptive learning, a stable bubbly steady state and the associated sunspot solutions under optimal monetary policy are not E-stable. When deriving the unique forward-looking minimum stable variable (MSV) solution around an unstable bubbly steady state, we obtain results that are consistent with the conventional views: leaning against the wind policy reduces bubble volatility and is optimal. Such a steady state and the associated MSV solution are E-stable