Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence

Abstract: During the first decade of the euro, southern countries experienced a boom-bust cycle in bank lending, non-tradable sector growth, and capital inflows. I develop a quantitative, open economy model of banking that is consistent with the banks’ behavior in credit allocation and foreign borrowing observed in Spanish data. I illustrate how movements in the frictions of cross-border deposits generate an endogenous asymmetric allocation of bank credit toward non-traded sectors, while producing a persistent and climbing current account deficit. A common central bank’s unconventional policies in response to sudden stops are successful at ameliorating the downturn.