The Domestic and International Effects of Interstate U.S. Banking

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 1111 August 2014 The Domestic and International E(cid:27)ects of Interstate U.S. Banking Matteo Cacciatore Fabio Ghironi Viktors Stebunovs NOTE: International Finance and Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IDFPs are available on the Web at www.federalreserve.gov/pubs/ifdp/. This paper can be downloaded without charge from Social Science Research Network electronic library at www.ssrn.com.

The Domestic and International E(cid:27)ects of Interstate U.S. Banking Matteo Cacciatore∗ Fabio Ghironi# Viktors Stebunovs† Abstract: This paper studies the domestic and international e(cid:27)ects of national bank market integration in a two-country, dynamic, stochastic, general equilibrium model with endogenous producer entry. Integration of banking across localities reduces the degree of local monopoly power of (cid:28)nancial intermediaries. The economy that implements this form of deregulation experiences increased producer entry, real exchange rate appreciation, and a current account de(cid:28)cit. The foreign economy experiences a long-run increase in GDP and consumption. Less monopoly power in (cid:28)nancial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution e(cid:27)ects in labor supply in response to productivity shocks. Bank market integration thus contributes to moderation of (cid:28)rm-level and aggregate output volatility. In turn, trade and (cid:28)nancial ties allow also the foreign economy to enjoy lower GDP volatility in most scenarios we consider. These results are consistent with features of U.S. and international (cid:29)uctuations after the United States began its transition to interstate banking in the late 1970s. Keywords: Business cycle volatility; Current account; Deregulation; Interstate banking; Producer entry; Real exchange rate. JEL classi(cid:28)cations: E32; F32; F41; G21. ∗HEC MontrØal, Institute of Applied Economics 3000, chemin de la C(cid:244)te-Sainte-Catherine, MontrØal,Quebec,Canada; matteo.cacciatore@hec.ca. URL:http://www.hec.ca/in/profs/ matteo.cacciatore. #Department of Economics, University of Washington, Savery Hall, Box 353330, Seattle, Washington, WA 98195, U.S.A.; ghiro@uw.edu. URL: http://faculty.washington.edu/ ghiro. †Board of Governors of the Federal Reserve System, Division of International Finance, 20th StreetandConstitutionAvenue,NW,Washington,DC20551,U.S.A.; viktors.stebunovs@frb.gov. URL: http://www.federalreserve.gov/econresdata/viktors-stebunovs.htm. The views in this paper are solely the responsibility of the authors and should not be interpreted as re(cid:29)ecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

1 Introduction The U.S. banking system was highly segmented within and across states until the late 1970s. For decades, a myriad of state and federal laws limited where banks could operate. States e(cid:27)ectively barred banks from other states, so the country had (cid:28)fty banking systems instead of one national banking system (Morgan, Rime, and Strahan, 2004). Moreover, most states also prohibited cross-county branching within the state, so the country e(cid:27)ectively had as many banking systems as counties. Starting in the late 1970s, successive waves of state-level deregulation lifted restrictions on bank expansion both within and across states. By the early 1990s, almost all states had removed such restrictions. The transition to interstate 1 banking was completed with passage of federal legislation in the mid 1990s. What are the domestic and international consequences of this type of (cid:28)nancial market reform? This paper addresses this question in a two-country, dynamic, stochastic, general equilibrium (DSGE) model with endogenous producer entry and a role for (cid:28)nancial intermediation. We argue that the removal of banking segmentation may have contributed to U.S. and international macroeconomic dynamics between the beginning of the 1980s and the mid-2000s. A growing literature emphasizes the role of producer entry as a mechanism for propa- 2 gation of domestic and international (cid:29)uctuations. With the exceptions of Notz (2012) and Stebunovs (2008), the models in this literature assume that entrants (cid:28)nance their entry costs by raising capital in a perfectly competitive stock market. However, bank (cid:28)nance is a more 3 realistic assumption for small (cid:28)rms, which represent a large portion of the U.S. economy. The structure of the banking system is thus likely to a(cid:27)ect entry decisions and the propagation of (cid:29)uctuations, and changes in the banking system itself can trigger macroeconomic dynamics through their impact on business creation. In fact, there is substantial empirical evidence of the connection between producer entry and the structure of banking in the United States. This evidence emphasizes that potential entrants in product markets face greater di(cid:30)culty gaining access to credit in localities where banking is concentrated and subject to tighter restrictions on geographical expansion than in localities where banking is more competitive (Black and Strahan, 2002, Cetorelli and Strahan, 2006, and Kerr and Nanda, 2007). These and other studies emphasize that the transition to interstate banking in the U.S.(cid:22)a form of (cid:28)nancial market deregulation(cid:22) reduced the local monopoly power of commercial banks, facilitating access to (cid:28)nance for new entrants in product markets and resulting in an increased number of operating non-(cid:28)nancial 4 establishments. We study the domestic and international e(cid:27)ects of such easier access to entry (cid:28)nance. Our model builds on Ghironi and Melitz (2005) and Bilbiie, Ghironi, and Melitz (2012) by 1 We provide a more detailed account of the removal of geographical restrictions to U.S. bank expansion in a separate online Appendix available at http://faculty.washington.edu/ghiro. 2 See,forinstance,Bilbiie,Ghironi,andMelitz(2012),Corsetti,Martin,andPesenti(2007,2013),Ghironi and Melitz (2005), Lewis (2006), MØjean (2008), Notz (2012), and Stebunovs (2008). 3 According to the U.S. Small Business Administration, small (cid:28)rms (with fewer than 500 employees) represent 99.7 percent of all (cid:28)rms, employ half of all private sector employees, and produce half of non-farm private GDP. 4 Jayaratne and Strahan (1998) and Dick (2006) (cid:28)nd that loan prices and net interest rate margins declined with the integration of U.S. bank markets. Berger, Demsetz, and Strahan (1999) document that the deregulation caused reduced concentration in local banking. See Stebunovs (2008) for a more detailed discussion. 1

assuming that investment in the economy takes the form of the creation of new production lines (for convenience, identi(cid:28)ed with (cid:28)rms). Sunk costs and a time-to-build lag induce the number of (cid:28)rms to respond slowly to shocks, consistent with the notion that the number of productive units is (cid:28)xed in the short run. Following Stebunovs (2008), we assume that new entrants must obtain funds from (cid:28)nancial intermediaries (henceforth, banks) to cover entry costs. Bank markets are initially segmented across di(cid:27)erent locations within each country in our model, and local market power induces banks to erect a (cid:28)nancial barrier to (cid:28)rm entry to protect the pro(cid:28)tability of lending. This reduces average entry relative to the competitive benchmark, as in the evidence documented by Black and Strahan (2002), 5 Cetorelli and Strahan (2006), and Kerr and Nanda (2007). We take bank concentration as exogenous, and we study the consequences of the removal of within-country banking segmentation, resulting in a decrease in the local monopoly power of banks, in one of the countries in our model. We show that the economy that implements this deregulation experiences increased producer entry, real exchange rate appreciation, and a current account de(cid:28)cit. Reduced local monopoly power of banks makes the economy that deregulates a relatively more attractive environment for potential entrants, and the number of (cid:28)rms that operate in the economy increases, consistent with the (cid:28)ndings of the empirical (cid:28)nance literature. Average (cid:28)rm size decreases, as documented by Cetorelli and Strahan (2006) and Kerr and Nanda (2007). As in Ghironi and Melitz (2005), entry in the economy that deregulates pushes relative labor costs upward, inducing real appreciation. (Non-traded goods and trade costs cause deviations from purchasing power parity(cid:22)PPP(cid:22)in the model.) Moreover, when we allow for international borrowing and lending, domestic bank market integration induces the economy that deregulates to run a current account de(cid:28)cit to (cid:28)nance increased (cid:28)rm entry. The foreign economy experiences higher GDP and consumption in the long run. Comparing business cycle (cid:29)uctuations around the pre- and post-deregulation steady states, we also show that less monopoly power in (cid:28)nancial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution effects in labor supply in response to productivity shocks(cid:22)the source of business cycles in our model. Removal of banking segmentation thus contributes to moderation of (cid:28)rm-level 6 and aggregate output volatility. In turn, trade and (cid:28)nancial ties between the two countries allow also the foreign economy to enjoy lower GDP volatility in most scenarios we consider. Welfare rises in both countries. Interpreting the economy that removes banking segmentation in our exercise as the United States, the predictions of our model are qualitatively consistent with features of U.S. and international macroeconomic dynamics following the waves of U.S. banking integration that started at the end of the 1970s: The U.S. experienced real appreciation and signi(cid:28)cant external borrowing in the (cid:28)rst half of the 1980s and after the mid-1990s(cid:22)periods that followed the (cid:28)rst wave of deregulation and the completion of the transition to interstate banking, respectively. The decades after the early 1980s(cid:22)and before the crisis that begun in 2007(cid:22)were also marked by a reduction of macroeconomic volatility. Thus, our paper o(cid:27)ers a new explanation of developments in the U.S. and international business cycle that 5 See also Bertrand, Schoar, and Thesmar (2007). Our model incorporates Cestone and White’s (2003) insight that entry deterrence takes place through (cid:28)nancial rather than product markets. 6 The reduction in (cid:28)rm-level volatility is consistent with evidence in Correa and Suarez (2007), who (cid:28)nd a causal link between banking deregulation and lower (cid:28)rm-level volatility in the U.S. 2

7 complements those already present in the literature. The conventional explanation for the contemporaneous occurrence of U.S. exchange rate appreciation and external borrowing in the 1980s relies on the traditional Mundell-Fleming analysis of the consequences of expansion in government spending and the monetary policy contraction implemented by Paul Volcker’s Federal Reserve. But the tight association between federal budget and external balance has been challenged by more recent literature. For instance, Erceg, Guerrieri, and Gust (2005) (cid:28)nd that a (cid:28)scal de(cid:28)cit has a relatively small e(cid:27)ect on the U.S. trade balance, irrespective of whether the source is a spending increase or a tax cut. With respect to U.S. trade balance and real exchange rate dynamics in the second half of the 1990s, Hunt and Rebucci (2005) conclude that accelerating productivity growth in the U.S. contributed only partly to appreciation and trade balance deterioration. Recent contributions highlight the role of (cid:28)nancial market characteristics and business cycle volatility as a source of external imbalances. Caballero, Farhi, and Gourinchas (2008) rationalize the burgeoning U.S. de(cid:28)cits since the mid-1990s as the outcome of heterogeneity in countries’ ability to generate (cid:28)nancial assets and cross-country growth rate di(cid:27)erentials. Mendoza, Quadrini, and R(cid:237)os-Rull (2009) argue that imbalances can be the outcome of international (cid:28)nancial integration when countries di(cid:27)er in (cid:28)nancial market development (interpreted as the enforcement of (cid:28)nancial contracts) and show that countries with more advanced (cid:28)nancial markets accumulate foreign liabilities in a gradual, long-lasting process. Finally, Fogli and Perri (2006) argue that imbalances are a consequence of business cycle moderation in the U.S. In their model, if a country experiences a fall in volatility greater than that of its partners, its relative incentive to accumulate precautionary savings weak- 8 ens, and this causes a deterioration of its external balance. The moderation of business cycle volatility between the 1980s and the crisis that began in 2007(cid:22)often referred to as the Great Moderation(cid:22)has been the subject of extensive literature that attributes it partly to 9 favorable changes in the shocks to the economy and partly to improved policy. Ourpapercomplementsthisliteraturebyhighlightingthee(cid:27)ectsofincreasedcompetition 10 in U.S. banking relative to the rest of the world. We emphasize that our results hinge on lower bank monopoly power at the local level. Even if bank consolidation was a documented phenomenon in the U.S. since the 1980s, it is well established by the empirical (cid:28)nance literature referenced above that interstate banking reduced the degree of bank monopoly power at 7 Since our model predicts permanent real appreciation following permanent banking deregulation, the model does not explain the return of the U.S. e(cid:27)ective real exchange rate to pre-appreciation levels after the appreciation phases in the 1980s and 1990s. This can be attributed to the reversal of other forces that contributedtoobservedexchangeratedynamics. Ifoneviewsintegratednationalbankingasacharacteristic ofmoredevelopedcountries,thepredictionofpersistentlyhigheraveragepricesisconsistentwiththeevidence of higher prices in high-income countries. 8 IncontrasttoFogliandPerri(2006),ourmodelandsolutionapproachimplythatprecautionarysavings play no role in the current account and real exchange rate dynamics caused by banking deregulation in our exercise. Other explanations of the recent dynamics of the U.S. external position emphasize demographics (Ferrero, 2007), a (cid:16)global saving glut(cid:17) (Bernanke, 2005), and valuation e(cid:27)ects (Gourinchas and Rey, 2007). 9 See Stock and Watson (2003) and references therein. An incomplete list of more recent contributions includesCogleyandSargent(2005),Giannone,Lenza,andReichlin(2008),JustinianoandPrimiceri(2008), and Sims and Zha (2006). 10 Ouranalysiscanofcoursebeappliedalsototheintra-Europeanandinternationalconsequencesofbank market integration within the European Union (EU) since the signing of the Single European Act in 1986. However, the process of EU banking integration has been lagging behind the implementation of interstate banking in the U.S. See the online Appendix for historical details. De Bandt and Davis (2000) provide evidencethatthebehavioroflargebanksinEuropewasnotascompetitiveasthatofU.S.counterpartsover the period 1992-1996. Regarding small banks, the level of competition in Europe was even lower. 3

the level of local borrowers(cid:22)put di(cid:27)erently, while the total number of U.S. banks may have declined as a result of consolidation, the number of those represented at any given location tended to increase, generating the e(cid:27)ects that we capture. In our model, a di(cid:27)erential in the competitiveness of the banking system induces real appreciation of the dollar and U.S. external borrowing by making the U.S. a more attractive environment for business creation. As in Caballero, Farhi, and Gourinchas (2008), Mendoza, Quadrini, and R(cid:237)os-Rull (2009), and Fogli and Perri (2006), current account de(cid:28)cit and the accumulation of a persistent (although not permanent) net foreign debt position arise as an equilibrium phenomenon. While Caballero, Fahri, and Gourinchas do not link business cycle moderation with global imbalances, and Fogli and Perri take moderation as exogenous, our model implies that both 11 external borrowing and eventual business cycle moderation occur endogenously. An element of similarity between our approach and those of Caballero, Fahri, and Gourinchas and Mendoza, Quadrini, and R(cid:237)os-Rull is that net foreign asset imbalances arise as a consequence of capital mobility across asymmetric (cid:28)nancial systems: In Caballero, Fahri, and Gourinchas, there is asymmetric ability to generate (cid:28)nancial assets; in Mendoza, Quadrini, and R(cid:237)os-Rull, there is asymmetric enforcement of (cid:28)nancial contracts; in our model, the removal of within-country bank market segmentation results in an asymmetric degree of banking 12 competition across countries. The remainder of the paper is organized as follows. Section 2 presents the model under a balanced trade assumption. Section 3 discusses real exchange rate determination and the mechanism for appreciation following banking deregulation. Section 4 presents a numerical exercise that substantiates the results and intuitions of Section 3. Section 5 introduces international capital (cid:29)ows to show the emergence of external borrowing in response to deregulation. Section 6 incorporates countercyclical (cid:28)rm markups and elastic labor supply to highlight the mechanism for the moderation of business cycle volatility. Section 7 concludes. The online Appendix(cid:22)henceforth referred to simply as the Appendix(cid:22)contains additional material and technical details. 2 The Model We begin by developing the model under (cid:28)nancial autarky. This allows us to focus on its most innovative features. The world consists of two countries, home and foreign. We denote foreign variables with an asterisk. Each country is populated by a unit mass of atomistic, identical households, a discrete number of banks, and a continuum of (cid:28)rms. In each country, there are several exogenously given locations with a discrete number of banks and a local continuum of (cid:28)rms in each of them. Monopolistically competitive (cid:28)rms in the traded sector must borrow from banks to (cid:28)nance sunk entry costs, and they have no collateral to pledge except a stream of 13 future pro(cid:28)ts. Each traded-sector (cid:28)rm produces a (cid:28)rm-speci(cid:28)c consumption good for sale 11 Ofcourse,ourmodeldoesnotexplain(anddoesnotaimtoexplain)theperiodof(cid:28)nancialmarketturmoil that began in 2007 and its business cycle implications. Extending the model to capture these phenomena is beyond the scope of this paper. 12 See also Niepmann (2012, 2013) on the role of di(cid:27)erences in the characteristics of the banking sector for international capital (cid:29)ows. 13 Financial frictions that we leave unspeci(cid:28)ed force prospective entrants to borrow the amount necessary to cover sunk entry costs from banks rather than raising funds in equity markets. Our model does not incorporate a theory of why banks exist or a role for banks in screening/monitoring in the presence of asymmetric information. We simply assume that bank intermediation is necessary, and we focus on the 4

in the domestic and export markets. Firm entry reduces the stream of future pro(cid:28)ts of both incumbents and entrants(cid:22)and thus the amount pledgeable for entry loan repayments(cid:22)by reducing the share of aggregate demand allocated to each (cid:28)rm. Before deregulation, (cid:28)rms are restricted to borrow from local banks. These use their monopoly power on the loans they issue to extract all the future pro(cid:28)ts from the prospective entrants they (cid:28)nance. Each bank holds a portfolio of outstanding loans and decides on the number of new loans to be issued (that is, on the number of entrants to be (cid:28)nanced) in each 14 period. Each bank trades the increase in revenue from expanding its portfolio of (cid:28)rms (portfolio expansion e(cid:27)ect) against the decrease in revenue from all (cid:28)rms in its portfolio due to reduced market share per (cid:28)rm (pro(cid:28)t destruction e(cid:27)ect). The pro(cid:28)t destruction e(cid:27)ect induces credit rationing at the extensive margin: Less prospective entrants receive funding than with perfectly competitive (cid:28)nancial markets. Each bank supplies one-period deposits to domestic households in a perfectly competitive deposit market. The bank then uses the deposits to fund (cid:28)rm entry. Thus, the cost that each bank faces is the deposit interest rate. Bank deregulation lifts the restriction on borrowing from banks at a di(cid:27)erent location within the country. The number of banks to which a borrower has access increases, hence reducing 15 bank monopoly power. For expositional simplicity, we present the model economy normalizing the number of banking locations in each country to 1. (This normalization is without loss of generality because we assume that locations are completely symmetric ex ante and ex post, and withincountry banking integration implies no net asset (cid:29)ows across locations.) We denote the number of banks represented at this location with H ≥ 1 (H∗ in the foreign country). If the number of locations were M > 1, following integration of the home banking market, the product HM would replace H in the equations where this appears below: Before deregulation, prospective entrants can borrow only from the H banks represented at their location; after deregulation, they can borrow from HM banks. Having normalized the number of locations to one, this is isomorphic to an increase in the number H of banks represented at this location. 16,17 consequences of changes in bank monopoly power. The key qualitative results of our exercise would be una(cid:27)ected in a richer model with a screening/monitoring role for banks that still captures the documented increase in non-(cid:28)nancial-sector entry generated by less bank monopoly power. For alternative models of banking with market power, see Bremus, Buch, Russ, and Schnitzer (2013), de Blas and Russ (2013), and Mandelman (2010, 2011). 14 Banks compete in the number of entrants in Cournot fashion as in the static, partial equilibrium model of GonzÆlez-Maestre and Granero (2003). Since banks extract all (cid:28)rm pro(cid:28)ts through loan repayments, banks de facto hold portfolios of (cid:28)rms in the economy. Financial intermediaries are equity holders also in Gertler and Karadi (2011). 15 Since the completion of deregulation in the U.S. in 1994, it is increasingly less plausible to view banking marketsaslocal(CetorelliandStrahan, 2006). Theabilityofbankstoexpandacrosslocalmarketsandnew technologies that allow banks to lend to distant borrowers act to limit the incumbent banks’ local monopoly power (Petersen and Rajan, 2002). 16 We remark that while the normalization M = 1 implies that H becomes the total number of home banks, our results do not hinge on deregulation resulting in an increase in the total number of home banks (in reality or in the model without normalization). In fact, consolidation lowered the total number of banks in the U.S. But this is not inconsistent with an increase in the number of banks represented in each location and a decline in their local monopoly power, which is what our model captures. 17 Weabstractfromendogenousentryintobankingasfunctionofeconomicconditions(forgivenregulatory environment). While there is evidence of cyclical variation of entry in goods markets (see Bilbiie, Ghironi, and Melitz, 2012, and references therein), the evidence of bank creation at business cycle frequency is less pervasive. 5

All contracts and prices in the world economy are written in nominal terms. Prices are (cid:29)exible. Thus, we only solve for the real variables in the model. However, as the composition of consumption baskets in the two countries changes over time (a(cid:27)ecting the de(cid:28)nitions of the consumption-based price indexes), we introduce money as a convenient unit of account for contracts. Money plays no other role. For this reason, we do not model the demand for cash currency, and we resort to a cashless economy as in Woodford (2003). We focus on the home economy in presenting the structure of the model and relegate equations for the foreign country to Table 1. Households The representative home household supplies L units of labor inelastically in each period at the nominal wage rate W , denominated in units of home currency. The household maxit mizes expected intertemporal utility from consumption C , E (cid:80)∞ βs−t(C )1−γ/(1−γ), t t s=t s where β ∈ (0,1) is the subjective discount factor and γ > 0 is the inverse of the intertemporal elasticity of substitution, subject to the budget constraint speci(cid:28)ed below. At time t, the household consumes the basket of goods C = (C /α)α[C /(1−α)]1−α , t T,t N,t where C is a basket of home and foreign tradable goods, C is a non-tradable good, T,t N,t and α ∈ (0,1] is the weight of the tradable basket in consumption. 18 The consumptionbased price index is P = (P )α(P )1−α , where P is the price index of the tradable t T,t N,t T,t basket, and P is the price of the non-tradable good. The basket of tradable goods is N,t C = (cid:0)(cid:82) c (ω)(θ−1)/θdω (cid:1)θ/(θ−1) , where θ > 1 is the symmetric elasticity of substitution. T,t ω∈Ω t At any given time t, only a subset of goods Ω ⊂ Ω is actually available for consumption at t home and abroad. Let p (ω) denote the home currency price of traded good ω ⊂ Ω . Then, t t (cid:16) (cid:82) (cid:17)1/(1−θ) P = p (ω)1−θdω . The household’s demand for each individual traded good T,t ω∈Ωt t ω is c (ω) = α(p (ω)/P )−θ(P /P )C . The household’s demand for the non-tradable t t T,t t T,t t good is C = (1−α)(P /P )C . N,t t N,t t The foreign household is modeled similarly. Importantly, the subset of tradable goods available for consumption in the foreign economy during period t coincides with the subset of tradable goods that are available in the home economy (Ω∗ = Ω ). t t Households in each country hold two types of assets: one-period deposits supplied by domestic banks and shares in a mutual fund of domestic banks. 19,20 We assume that deposits pay risk-free, consumption-based real returns. (Nominal returns are indexed to consumer price in(cid:29)ation, so that deposits provide a risk-free, real return in units of the consumption basket.) Let x be the share in the mutual fund of H home banks held by the representative t home household entering period t. The mutual fund pays a total pro(cid:28)t in each period (in 18 Di(cid:27)erentlyfromGhironiandMelitz(2005),wedonotmodeltheendogenousdeterminationofthesubset oftradedgoodswithinatradableset,sincethisisnotcentraltotheanalysisinthispaper. Alltradablegoods that are produced in equilibrium are also traded, and there is an exogenously non-tradable good in each country. We present in the Appendix an alternative version of the model in which there is no non-tradable good, and home bias in consumption preferences for tradable goods is the source of PPP deviations. 19 Because of the assumption that banks de facto own domestic (cid:28)rms, this implies that households are the ultimate owners of the (cid:28)rms. However, as we show below, bank monopoly power in lending distorts the allocation of funds from the competitive deposit market to (cid:28)rms. 20 Theassumptionthatbankslendlocallybutcollectdepositsinacountry-widedepositmarketsubstitutes a scenario in which deposits are collected locally but there is country-wide interbank lending. The latter scenario would require to study the determination of the interbank lending rate in an environment with non-atomistic banks. 6

(cid:80) units of currency) equal to the total pro(cid:28)t of all home banks, P π (h), where π (h) t h∈H t t denotes the pro(cid:28)t of home bank h. During period t, the household buys x shares in the t+1 mutual fund. The date t price (in units of currency) of a claim to the future pro(cid:28)t stream of the mutual fund is equal to the nominal price of claims to future pro(cid:28)ts of home banks, (cid:80) P v (h), where v (h) is the price of claims to future pro(cid:28)ts of bank h. In addition to t h∈H t t mutual fund share holdings x , the household enters period t with deposits B in units of t t consumption. It receives gross interest income on deposits, dividend income on mutual fund shareholdings, thevalueofsellingitsinitialshareposition, andlaborincome. Thehousehold allocates these resources between consumption and purchases of deposits and shares to be carried into next period. The period budget constraint (in units of consumption) is (cid:88) (cid:88) B +x v (h)+C = (1+r )B +x (π (h)+v (h))+w L, (1) t+1 t+1 t t t t t t t t h∈H h∈H where r is the consumption-based interest rate on holdings of deposits between t − 1 and t t (known with certainty at t − 1), and w = W /P is the real wage. The home household t t t maximizes its expected intertemporal utility subject to (1). The Euler equations for deposits and share holdings are: 1 = β(1+r )E (cid:2) (C /C )−γ(cid:3) t+1 t t+1 t and v = βE (cid:2) (C /C )−γ(π +v ) (cid:3) , where v ≡ (cid:80) v (h) and π ≡ (cid:80) π (h). t t t+1 t t+1 t+1 t h∈H t t+1 h∈H t+1 We omit the transversality conditions for deposits and shares. Forward iteration of the Euler equation for share holdings and absence of speculative bubbles yield the value of the mutual fund, v , as expected present discounted value of the stream of bank pro(cid:28)ts, {π }∞ . t s s=t+1 Similar Euler equations, transversality conditions, and expression for v∗ hold abroad. t Firms Traded Goods Producers There is a continuum traded-sector of (cid:28)rms in each country, each producing a di(cid:27)erent traded variety ω ∈ Ω. Aggregate labor productivity is indexed by Z , which represents the t e(cid:27)ectiveness of one unit of home labor. Production requires only one factor, labor: The output of (cid:28)rm ω is y (ω) = Z l (ω), where l (ω) is the amount of labor employed by the t t t t (cid:28)rm. The unit production cost, measured in units of consumption, is w /Z . Traded goods t t producers serve both their domestic and export markets. Exporting is costly, and it involves a melting-iceberg trade cost τ > 1. Foreign traded-sector (cid:28)rms are modeled similarly. Alltradedgoodsproducersfacearesidualdemandcurvewithconstantelasticityθ inboth markets, and they set (cid:29)exible prices that re(cid:29)ect the same proportional markup µ ≡ θ/(θ−1) over marginal cost. Let p (ω) and p (ω) denote the nominal domestic and export prices of D,t X,t a home (cid:28)rm (in the currency of the destination market). De(cid:28)ne the relative prices ρ (ω) ≡ D,t p (ω)/P , ρ ≡ P /P , ρ (ω) ≡ p (ω)/P∗ , and ρ∗ ≡ P∗ /P∗. Then, ρ (ω) = D,t T,t T,t T,t t X,t X,t T,t T,t T,t t D,t (ρ )−1µw /Z andρ (ω) = (cid:0) ρ∗ (cid:1)−1 τQ−1µw /Z ,whereQ = ε P∗/P istheconsumption- T,t t t X,t T,t t t t t t t t based real exchange rate (units of home consumption per unit of foreign consumption), and ε is the nominal exchange rate (units of home currency per unit of foreign). Total pro(cid:28)ts of t (cid:28)rm ω in period t are given by d (ω) = d (ω)+d (ω), where d (ω) = α(ρ (ω))1−θC /θ t D,t X,t D,t D,t t denotes pro(cid:28)ts from domestic sales and d (ω) = αQ (ρ (ω))1−θC∗/θ denotes pro(cid:28)ts from X,t t X,t t exports. Since all (cid:28)rms behave identically in equilibrium, we drop the index ω below. 21 21 Symmetryacrosstradedgoodsproducerswithineachcountryimpliesthatourframeworkwillnotcapture the reallocation e(cid:27)ects of banking deregulation across (cid:28)rms highlighted by Bertrand, Schoar, and Thesmar 7

Non-Traded Good Producers There is a constant mass of (cid:28)rms in each country producing the homogeneous non-traded good. These (cid:28)rms are perfectly competitive and possess the same technology as the (cid:28)rms 22 producing traded goods. Labor is perfectly mobile across sectors in each country. Hence, the price of the non-traded good, in real terms relative to the domestic price index, is given by ρ = P /P = w /Z . Foreign non-traded good producers behave similarly. N,t N,t t t t Banks and Firm Entry In every period there is an unbounded number of prospective entrants in both countries’ traded sectors. Prior to entry, (cid:28)rms face a sunk entry cost of one e(cid:27)ective labor unit, equal to w /Z units of consumption in the home country (w∗/Z∗ units of foreign consumption t t t t abroad). Since there are no (cid:28)xed production costs, all (cid:28)rms produce in every period, until they are hit with an exogenous exit shock, which occurs with probability δ ∈ (0,1) in every period. Entrants are forward looking, and correctly anticipate their future expected pro(cid:28)ts d in every period as well as the probability δ (in every period) of incurring the exit-inducing t shock. Unspeci(cid:28)ed (cid:28)nancial frictions force entrants to borrow the amount necessary to cover the sunk entry cost from a local bank in the (cid:28)rm’s domestic market. Since the bank has all the bargaining power, it sets the entry loan repayment in each period at d to extract all the t 23 (cid:28)rm pro(cid:28)t. There is a number H of forward looking banks in the home country, which compete in Cournot fashion over the number of loans issued. Each bank takes the decisions of its competitors as given. Bank h has N (h) producing (cid:28)rms in its portfolio and decides simult taneously with other banks on the number of entrants to fund, N (h), taking into account E,t 24 the post-entry (cid:28)rm pro(cid:28)t maximization as each (cid:28)rm sets optimal prices for its product. We assume that entrants at time t only start producing at time t+1, which introduces a one-period time-to-build lag in the model. The exogenous exit shock occurs at the very end of the time period (after production and entry). A proportion of new entrants will therefore never produce. The bank does not know which (cid:28)rms will be hit by the exogenous exit shock δ at the very end of period t. The timing of entry and production implies that the number of (cid:28)rms in bank h’s portfolio during period t is given by N (h) = (1−δ)(N (h)+N (h)). t t−1 E,t−1 Then, the number of producing home (cid:28)rms in period t is N = (1−δ)(N +N ), where t t−1 E,t−1 (cid:80) (cid:80) N = N (h), and the number of home entrants is N = N (h). As in Bilbiie, t h∈H t E,t h∈H E,t Ghironi, and Melitz (2012) and Ghironi and Melitz (2005), the number of producing (cid:28)rms in period t is an endogenous state variable that behaves like physical capital in standard real business cycle models. (2007) and Kerr and Nanda (2007). 22 For simplicity, we assume identical labor productivity across traded and non-traded sectors (and across production of existing goods and creation of new products in the traded sector(cid:22)see below). Productivity di(cid:27)erences between traded and non-traded sectors would not alter our main results. 23 Theassumptionthatbankshaveallthebargainingpowerandareabletoextractallthepro(cid:28)tsimpli(cid:28)es themodelsolutionsubstantially. Relativetoadebtcontract,itisnotnecessarytokeeptrackofoutstanding loan amounts for each cohort of (cid:28)rms, making it possible to treat (cid:28)rms of di(cid:27)erent vintages equally. Notz (2012) extends Stebunovs (2008) to incorporate (cid:28)nancial intermediation as in Kiyotaki and Moore (1997). Notz’sresultssuggestthatthekeymechanismsofourmodelwouldstilloperate(cid:22)andthemainresultswould not be a(cid:27)ected(cid:22)as long as the debt contract (or other contracts between banks and (cid:28)rms) does not alter the fact that deregulation facilitates access to (cid:28)nance. 24 Aswillbecomeclearlater,thisisnotexactlythestaticCournotmodelasnotonlythevalueofentrants, but also the value of incumbents depends on the number of entrants. 8

The Euler equation for household holdings of shares in the bank fund implies that the objectivefunctionforbankhisE (cid:80)∞ βs−t(C /C )−γπ (h),whichthebankmaximizeswith t s=t s t s respect to {N (h)}∞ and {N (h)}∞ . Bank h’s pro(cid:28)t is π (h) = N (h)d + B (h) − s+1 s=t E,s s=t t t t t+1 (w /Z )N (h) − (1+r )B (h), where d N (h) is the revenue from bank h’s portfolio of t t E,t t t t t N (h) outstanding loans (or producing (cid:28)rms), B (h) denotes household deposits into bank t t+1 (cid:80) h entering period t+1 (so that B = B (h)), (w /Z )N (h) is the amount lent t+1 h∈H t+1 t t E,t to N (h) entrants, and (1+r )B (h) is the principal and interest on the previous period’s E,t t t deposits. We assume that banks accrue revenues after (cid:28)rm entry has been funded and then rebate pro(cid:28)ts to the mutual fund owned by households. Hence, bank h’s balance sheet constraint is B (h) = (w /Z )N (h). In solving its optimization problem, bank h takes t+1 t t E,t aggregate consumption, wages, and the interest rate as given. The (cid:28)rst-order condition with respect to N (h) yields the Euler equation for the value t+1 of a (cid:28)rm producing in period t + 1 to bank h, q (h), which involves a term capturing the t bank’s internalization of the pro(cid:28)t destruction externality (PDE) generated by (cid:28)rm entry:        (cid:18) C t+1 (cid:19)−γ  ∂d t+1 ∂N t+1    q (h) = βE d +N (h) +(1−δ)q (h) . t t t+1 t+1 t+1 C  ∂N ∂N (h)   t t+1 t+1     (cid:124) (cid:123)(cid:122) (cid:125)  InternalizationofPDE The bank internalizes the e(cid:27)ect of entry on (cid:28)rm pro(cid:28)ts through the e(cid:27)ect of entry on the domestic and export relative prices ρ and ρ . Firm entry reduces (cid:28)rm size and prof- D,t X,t its, and hence decreases the repayments to the bank. The bank internalizes only the effects of the entry it funds. Hence, N (h) multiplies the pro(cid:28)t destruction externality, t+1 (∂d /∂N )(∂N /∂N (h)). (See the Appendix for details.) t+1 t+1 t+1 t+1 The (cid:28)rst-order condition with respect to N (h) de(cid:28)nes a (cid:28)rm entry condition, which E,t holds with equality as long as the number of entrants, N (h), is positive. We veri(cid:28)ed E,t that this is the case in every period in all our exercises. Entry occurs until the value of an additional producer to the bank, q (h), is equalized with the expected, discounted entry cost, t given by the deposit principal and the interest to be paid back at t+1: β w (cid:18) C (cid:19)−γ 1 w t t+1 t q (h) = (1+r ) E = , (2) t t+1 t 1−δ Z C 1−δ Z t t t where the second equality follows from the household’s Euler equation for deposits. The cost of creating a (cid:28)rm to be repaid at t+1 is known with certainty as of period t. As there is no di(cid:27)erence between the bank’s valuation of a marginal new entrant and its valuation of an incumbent, (cid:28)rm entry reduces not only the value of entering (cid:28)rms, but also the value of incumbents until the value of all (cid:28)rms is equalized with the sunk entry cost (adjusted by a 25 premium for the risk of (cid:28)rm exit). Since all banks are identical, we impose symmetry to obtain the Nash equilibrium. The 25 The (cid:28)rst-order condition with respect to the number of entrants in period t recognizes that some of these entrants will be hit by the exit shock and will not produce and repay the loan at t+1. To compensate the bank for the risk of entrant death, the entry condition requires that q (h) be higher than the entry cost t by the factor 1/(1−δ). 9

equation for (cid:28)rm value, q , becomes: t (cid:40) (cid:41) (cid:18) C (cid:19)−γ(cid:20)(cid:18) 1 (cid:19) (cid:21) t+1 q = βE 1− d +(1−δ)q . (3) t t t+1 t+1 C H t TheparameterH playsthesameroleinthebankingmarketthatθ playsinthegoodsmarket. At one extreme, H = 1 or absolute bank monopoly, equation (3) implies that there is no entry as the marginal (and average) return from funding an entrant is zero: The portfolio 26 expansion e(cid:27)ect is totally o(cid:27)set by pro(cid:28)t destruction. The economy is starved of (cid:28)rm entry(cid:22)and thus, eventually, of any activity. 27 Bank market power decreases as H increases. At the other extreme, H → ∞, equation (3) simpli(cid:28)es to the usual asset pricing equation of a perfectly competitive market. Equation (3) allows us to relate our results on the e(cid:27)ects of bank monopoly power on (cid:28)rm creation to Hayashi’s (1982) results on the consequences of (cid:28)rm monopoly power for capital accumulation. Solving (3) forward yields: (cid:18) 1 (cid:19) (cid:88) ∞ (cid:18) C (cid:19)−γ (cid:18) 1 (cid:19) q = 1− E βs−t(1−δ)s−(t+1) s d = 1− qA, t H t C s H t t s=t+1 whereqA ≡ E (cid:80)∞ βs−t(1−δ)s−(t+1)(C /C )−γd correspondstotheaverageq ofHayashi t t s=t+1 s t s (1982): qA would be the valuation of an additional (cid:28)rm (or unit of capital) producing at time t t+1 generated by a perfectly competitive (cid:28)nancial market (for instance, by a competitive market for shares in (cid:28)rms). As demonstrated by Hayashi, the existence of monopoly power induces a discrepancy between average q and marginal q(cid:22)the measure of q that determines decisions. In our model, monopoly power in banking results in a proportional mark-down ((H −1)/H) of the value of (cid:28)rms to the bank relative to the competitive valuation (much as monopoly power in production of goods results in a proportional markup (θ−1)/θ relative to competitive pricing and would induce marginal q to be lower than average q if (cid:28)rms accumulated capital). As in Hayashi’s capital accumulation model, the discrepancy between average and marginal q disappears as the economy approaches the competitive benchmark (H → ∞). Monopoly power causes marginal q to be below average q because additional (cid:28)rm creation (or capital accumulation) con(cid:29)icts with a monopolist’s incentive to reduce supply relative to the competitive benchmark in order to generate higher pro(cid:28)t. The results of our model thus parallel those of traditional theory of capital accumulation. Although the model does not feature an explicit bank markup, we can de(cid:28)ne a measure of ex post bank markup as µ ≡ d N /(q N ) − r . The ratio d N /(q N ) measures B,t t t t t+1 t t t t t+1 the relative return from funding a marginal (and average) (cid:28)rm. Similar equations and bank 28 markup de(cid:28)nition hold abroad. (cid:104) (cid:105) 26 When H =1, equation (3) becomes q =β(1−δ)E (C /C )−γq . This is a contraction mapping t t t+1 t t+1 because of discounting, and by forward iteration under the assumption lim [β(1−δ)]T E q =0 (the T→∞ t t+T value of (cid:28)rms is zero when reaching the terminal period), the only stable solution is q = 0, which implies t N =0. E,t 27N falls to 0 over time if the economy had started with higher H and a positive number of (cid:28)rms. This t starvation of the economy would not happen if we assumed that the single monopolist bank takes into account its in(cid:29)uence on aggregate consumption. This would be reminiscent of the (cid:16)Ford e(cid:27)ect(cid:17) described in D’Aspremont, Ferreira, and Gerard-Varet (1996). 28 Analternative de(cid:28)nitionofbankmarkup isµ ≡d N /(q N )−r =d /q −r . Inthisde(cid:28)nition, B,t t t t−1 t t t t−1 t 10

Aggregate Accounting and Balanced Trade Aggregating the budget constraint (1) across home households and imposing the equilibrium conditions x = x = 1 and B = (w /Z )N yields the aggregate accounting equation t+1 t t+1 t t E,t C +B = d N +w L. Consumptionineachperiodmustequallaborincomeplusinvestment t t+1 t t t income net of the cost of investing in new (cid:28)rms. Since this cost, B = (w /Z )N , is the t+1 t t E,t value of home investment in new (cid:28)rms, aggregate accounting also states the familiar equality of spending (consumption plus investment) and income (labor plus dividend). The righthand side of the aggregate accounting equation de(cid:28)nes GDP from the income side of the economy; the left-hand side de(cid:28)nes GDP from the spending side. We denote GDP with Y t below. To close the model, observe that (cid:28)nancial autarky implies balanced trade: The value of home exports must equal the value of foreign exports. Hence, Q N (ρ )1−θC∗ = t t X,t t N∗ (cid:0) ρ∗ (cid:1)1−θ C . As in Ghironi and Melitz (2005), balanced trade under (cid:28)nancial autarky t X,t t implies labor market clearing: Aggregate labor supply must be equal to the total amount of labor employed in production of goods and creation of new (cid:28)rms: L = (θ−1)d N /w + t t t N /Z +(1−α)C /(Z ρ ). Fluctuations result in reallocation of labor between produc- E,t t t t N,t tion of existing goods and creation of new ones. Model Summary Table 1 summarizes the main equilibrium conditions of the model. The equations in the table constitute a system of 29 equations in 29 variables endogenously determined at time t: r , w , d , π , q , N , v , ρ , ρ , ρ , ρ , N , B , C , r∗ , w∗, d∗, π∗, q∗, N∗ , t+1 t t t t E,t t D,t X,t T,t N,t t+1 t+1 t t+1 t t t t E,t v∗, ρ∗ , ρ∗ , ρ∗ , ρ∗ , N∗ , B∗ , C∗, Q . The model features two exogenous variables: t D,t X,t T,t D,t t+1 t+1 t t the aggregate productivities Z and Z∗. We model domestic bank market integration as t t a one-time, permanent increase in the number of home banks, H. Since this is the only change we allow in the number of banks, we do not denote the latter with a time subscript to economize on notation. 3 Interstate Banking and the Real Exchange Rate This section discusses real exchange rate determination in our model and the mechanism for appreciation following banking deregulation. A property of our model with exogenously non-traded goods isthat we do notneed to di(cid:27)erentiate betweenwelfare-consistent anddataconsistent real exchange rates. As discussed in Ghironi and Melitz (2005), welfare-consistent price indexes in this class of models must be adjusted by removing pure variety e(cid:27)ects in order to obtain price indexes that correspond to the data. In Ghironi and Melitz’s model q is the t−1 value to the bank of an additional (cid:28)rm producing at t (whose entry was funded at t−1), t−1 d is the realized return that this same (cid:28)rm generates. The benchmark de(cid:28)nition compares the return from t (cid:28)rms that were funded in period t−1 (and earlier) to the value of (cid:28)rms producing at t+1 and funded in period t, i.e., there is a discrepancy in the timing of entry funding at numerator and denominator of d N /(q N ). By focusing on (cid:16)the same (cid:28)rm,(cid:17) the alternative de(cid:28)nition provides a more accurate measure t t t t+1 of the return from funding an entrant. However, the benchmark de(cid:28)nition is closer to empirical measures of bank interest margins. Importantly, both de(cid:28)nitions imply countercyclical responses of the bank markup to shocks. Moreover, the de(cid:28)nitions are identical in steady state. Since we use only the steady-state markup for calibration, the di(cid:27)erence between de(cid:28)nitions is immaterial for our results. 11

with endogenously non-traded goods, this implies a di(cid:27)erence between welfare- and dataconsistent real exchange rates. By contrast, in our model, consumers have access to the same set of tradable (and traded) goods in the two countries, and they attach identical weights to non-tradable consumption. This implies that welfare- and data-consistent real exchange rates coincide. (See the Appendix for details. This property no longer holds in the model with home bias, as we show in the Appendix.) Using the price index equations, we obtain: (cid:34) N t ∗ (TOL )1−θ +τ1−θ (cid:35) 1− α θ Q = (TOL )1−α Nt t , (4) t t 1+ N t ∗ (τ∗TOL )1−θ Nt t where,followingGhironiandMelitz(2005),wede(cid:28)nedthetermsoflaborTOL ≡ ε (W∗/Z∗)/(W /Z ). t t t t t t The terms of labor measure the relative cost of e(cid:27)ective labor across countries. A decrease in TOL indicates an appreciation of home e(cid:27)ective labor relative to foreign. Note that, absent t trade costs (τ = τ∗ = 1), the real exchange rate reduces to Q = (TOL )1−α , re(cid:29)ecting the t t presence of non-traded goods with weight 1−α in consumption. PPP holds if there are no trade costs and α = 1. Dropping time subscripts to denote a variable’s level in steady state, we assume Z = Z∗ = 1. Assume further that the number of banks is equal in the two countries in the initial steady state (H = H∗) and that τ = τ∗ and L = L∗ = 1. The model then features a unique, symmetric steady state with Q = TOL = 1. (The solution for the steady-state levels of selected variables is in the Appendix.) Log-linearizing equation (4) around the steady state yields: (cid:18) 2τ1−θ (cid:19) α (cid:0) 1−τ1−θ (cid:1) Q = 1−α TOL + (N −N∗), (5) t 1+τ1−θ t (θ−1)(1+τ1−θ) t t where we use sans serif fonts to denote percentage deviations from the steady state. It is possibletoverifythatthecoe(cid:30)cientsofTOL andN −N∗ inthisequationarestrictlypositive t t t (as long as τ > 1). An appreciation of home e(cid:27)ective labor relative to foreign induces real exchange rate appreciation. In the absence of trade costs, this is motivated by an increase in the relative price of the non-traded good. Trade costs strengthen the e(cid:27)ect of the terms of labor on the real exchange rate (since 2τ1−θ < 1+τ1−θ) by causing the appreciation of the former to induce an increase also in the relative price of home traded goods. In contrast, an increase in the number of home traded goods relative to foreign induces the real exchange rate to depreciate. The reason is that the number of varieties on which home households are not paying trade costs rises, with a positive welfare e(cid:27)ect. (The portion α/(θ−1) of the coe(cid:30)cient of N −N∗ re(cid:29)ects the welfare bene(cid:28)t of additional traded goods.) The empirically t t plausible restriction θ > 3/2 is su(cid:30)cient for the coe(cid:30)cient of TOL to be strictly larger than t the coe(cid:30)cient of N −N∗ in equation (5). t t Consider now a permanent increase in the number of home banks H (holding the number of foreign banks constant). Reduced monopoly power induces home banks to (cid:28)nance a larger 29 number of entrants. This amounts to a decrease in e(cid:27)ective entry costs facing (cid:28)rms. From 29 Relative to the deregulation scenarios studied in Ghironi and Melitz (2005) and Cacciatore, Fiori, and Ghironi (2013), in which deregulation is modeled as an exogenous reduction in sunk entry cost, here(cid:22)as in Stebunovs (2008)(cid:22)banking deregulation lowers the (cid:28)nancial barrier to entry erected by banks for given size of exogenous sunk costs by narrowing the gap between the marginal value of an additional (cid:28)rm to a monopolistic bank and its perfectly competitive counterpart. The e(cid:27)ects on (cid:28)rm behavior are intuitively similar. 12

the perspective of prospective entrants, relative to the old steady state, the decrease in monopoly power of home banks makes the home economy a more attractive location. Absent any change in the relative cost of e(cid:27)ective labor (TOL ), all new (cid:28)rms would only enter the t home economy (there would be no new entrants into foreign). Thus, in the new long-run equilibrium, home e(cid:27)ective labor must appreciate (TOL must decrease) in order to keep t 30 the foreign traded sector from disappearing. It is precisely the entry of a larger number of (cid:28)rms into home that puts pressure on home labor demand and induces the terms of labor to appreciate. In turn, this causes real exchange rate appreciation as described above. As we show below, for plausible parameter values, the terms of labor e(cid:27)ect prevails on the variety term in equation (5), implying that an economy with permanently more competitive banking 31 (relative to its trading partners) has a permanently appreciated real exchange rate. To conclude this section, we note that the results and intuitions we discussed do not depend on the assumption of (cid:28)nancial autarky. Equations (4)(cid:21)(5) hold also when households can hold deposits abroad (or under any other assumption on international asset markets), and terms of labor and variety remain the fundamental determinants of real exchange rate dynamics. 4 Interstate Banking and Macroeconomic Dynamics under Financial Autarky Inthissection, wesubstantiatetheresultsandintuitionsofSection3bymeansofanumerical example, which allows us to characterize the full response path of the home and foreign economies to home banking deregulation from the impact period of the shock to the new long run. For consistency with the discussion in Section 3, we log-linearize the system in Table 1 around the initial, symmetric steady state under assumptions of log-normality and homoskedasticity. We veri(cid:28)ed that a global, Newton-type solution algorithm yields similar results. Calibration We interpret periods as quarters and set β = 0.99 and γ = 1, both standard choices for quarterly business cycle models. (The choice of log utility from consumption is motivated by consistency with the elastic labor supply case below, where we restrict utility to the log case for the properties of separable preferences discussed by King, Plosser, and Rebelo, 1988.) We follow Ghironi and Melitz (2005) for the calibration of most remaining parameters. We set the size of the exogenous (cid:28)rm exit shock δ = 0.025 to match the U. S. empirical level of 10 percent job destruction per year. 32 We posit θ = 3.8, which (cid:28)ts U.S. plant and macro 30 Absent entry into the foreign country, the number of foreign traded-sector (cid:28)rms would steadily decrease with the exit shock. 31 Terms of labor dynamics are also the key determinant of the terms of trade in our model. The terms of trade are given by T ≡ ε p /p∗ = (τ/τ∗)TOL−1. Hence, appreciation of the terms of labor implies an t t X,t X,t t improvement in the terms of trade. 32 Empirically, job destruction is induced by both (cid:28)rm exit and contraction. We include the latter portion of job destruction in the exit shock in our model, consistent with interpreting productive units also as production lines within potentially multi-product (cid:28)rms. The fraction of (cid:28)rm closures and bankruptcies over the total number of (cid:28)rms reported by the U.S. Small Business Administration(cid:22)consistently around 10 percent per year over the recent years(cid:22)yields the same calibration. 13

33 trade data as shown by Bernard, Eaton, Jensen, and Kortum (2003). We postulate that τ = τ∗ = 1.33, which is in line with Anderson and van Wincoop (2004) and Obstfeld and Rogo(cid:27) (2001). Given the trade cost, we calibrate the share of tradable goods in consumption to match the average 12 percent U.S. import share of GDP. (The steady-state import share of GDP is αN∗(ρ∗ )1−θC/Y.) This results in α = 0.397. As noted above, we set labor e(cid:27)ort, X L = L∗, and steady-state productivity, Z = Z∗, equal to 1 without loss of generality. These parameters determine the size of economy but leave dynamics una(cid:27)ected. With respect to banking, we set the initial steady-state number of banks H = H∗ such that it implies a bank markup of about 10 percentage points. To determine the size of the banking deregulation shock, we calculate the change in H that induces a 12 percent long-run increase in the number of (cid:28)rms in the home country. This choice is based on the evidence from the empirical (cid:28)nance literature: Using the new business incorporations series compiled by Dun and Bradstreet Corporation, Black and Strahan (2002) (cid:28)nd that the number of new incorporations per capita rose by 3.8 percent following the removal of restrictions on intrastatebranching; thenumberofnewincorporationspercapitarosebyanother7.9percent following the removal of restrictions on interstate banking. Hence, the move from pervasive segmentation (no branching or interstate banking) to integrated banking (branching and interstate banking) increased the number of non-(cid:28)nancial establishments by 11.7 percentage points. Using the County Business Patterns series compiled by the Census Bureau, Cetorelli and Strahan (2006) (cid:28)nd that the transition to interstate banking and the associated increase in banking competition increased the number of non-(cid:28)nancial establishments by 11.6 percent and reduced establishment size by 12.3 percent in the external-(cid:28)nance-dependent sectors relativetonon-dependentsectors. 34 Importantly, thesizeofthechangeinH thatweconsider does not a(cid:27)ect qualitative results. Impulse Responses Figure 1 shows selected responses (percent deviations from steady state) to a permanent banking deregulation in the home economy. The number of quarters after the shock is on the horizontal axis. In plot titles, H refers to home and F to foreign. Consider (cid:28)rst the long-run e(cid:27)ects in the new steady state. These substantiate the discussion in Section 3. With the fall in bank monopoly power, the home economy draws a permanently higher number of entrants: Pro(cid:28)ts per (cid:28)rm, d , are permanently lower, as (cid:28)rms t are now smaller. This results in a lower valuation of (cid:28)rms under perfectly competitive (cid:28)nance, qA (not shown). However, this is more than o(cid:27)set by the smaller mark-down of qA t t implied by a larger number of banks, H. This implies that the value of (cid:28)rms to banks, q , rises, eliciting more entry. Lower bank monopoly power also translates in a lower bank t markup, µ , pro(cid:28)ts, π , and prices of bank shares, v . The return on bank shares is pinned B,t t t down by the discount factor β in steady state, so there is no long-run e(cid:27)ect of the banking deregulation on this variable. Increased (cid:28)nancing of entry translates into a permanently higher number of producers and generates higher labor demand and upward pressure on wages. This induces the terms of labor, TOL , to appreciate, causing appreciation of the t 33 The main qualitative features of our results are not a(cid:27)ected if we set θ =6. 34 Using the Longitudinal Business Database compiled by the Census Bureau, Kerr and Nanda (2006) (cid:28)nd that interstate banking increased the entry of startups by 11 percent relative to facility expansions by existing (cid:28)rms. Further, they (cid:28)nd that interstate deregulation increased the entry of small startups, with 20 or fewer employees, by 15 to 22 percent relative to facility expansions by existing (cid:28)rms. 14

real exchange rate, Q . The less regulated economy exhibits higher prices relative to its tradt 35 ing partner. Consumption increases at home and abroad, due to higher income and the access to a larger range of (home) tradable goods. Notice that the number of foreign (cid:28)rms is essentially una(cid:27)ected: While foreign (cid:28)rm pro(cid:28)ts are higher as a consequence of higher consumption demand, and q∗ rises, there is no noticeable adjustment in foreign entry. This t mirrors Ghironi and Melitz’s (2005) result that home product market deregulation causes 36 increased domestic entry but has a very small e(cid:27)ect on foreign entry. We next describe the transitional dynamics in response to the permanent deregulation. Absent sunk entry costs, and the associated time-to-build lag before production, the number of producing (cid:28)rms, N , would immediately adjust to its new steady-state level. Sunk costs t and time-to-build transform N into a state variable that behaves very much like a capital t stock: The number of entrants, N , represents home investment, which translates into E,t increases in the stock N over time. (The (cid:28)gures plot the end-of-period response of the t number of (cid:28)rms.) The terms of labor steadily appreciate with the increase in home labor demandgeneratedbyentry. ThegradualincreaseinN anddomesticlaborcostsisassociated t with gradually declining (cid:28)rm pro(cid:28)ts, d , after the initial fall. The paths of (cid:28)rm pro(cid:28)ts and t consumption at home combine to produce an impact decline in qA that overshoots the new t long-run level before increasing toward it. As a consequence, q (a re-scaling of qA) rises t t on impact and during the transition. While the bank markup, µ , declines monotonically, B,t bank pro(cid:28)ts, π , fall in the short term by more than in the long run and converge toward t the new long-run level from below, re(cid:29)ecting the gradual expansion in the portfolio of loans. This is mirrored in the behavior of bank share prices, v . The return from holding bank t shares rises on impact and returns to the steady state monotonically. As we shall note in more detail below, the countercyclical response of bank markups to shocks in our model is consistent with the empirical evidence. The dynamics of several foreign variables are qualitatively similar to those at home. Perhaps the most signi(cid:28)cant di(cid:27)erence is that foreign (cid:28)rm pro(cid:28)ts fall initially, but rise above the initial steady state quickly. This causes qA∗, q∗, and the price of shares in foreign banks t t to rise above the initial level shortly after an impact decline. Home consumption decreases in the short run, as households save to (cid:28)nance the entry of new (cid:28)rms with increased deposits into banks. Foreign consumption also falls in the short run, as foreign real depreciation increases the cost of purchasing home goods. We note that the real exchange rate change unfoldsslowly. Reachingthenewlong-runleveltakesoversevenyears. Finally, GDPinitially declines in both countries before rising above the initial level. As shown in the Appendix, the responses to banking deregulation are qualitatively similar when the model features home 35 As noted above, if banking integration is associated with economic development, this is consistent with the Harrod-Balassa-Samuelson evidence that more developed economies exhibit appreciated real exchange rates relative to their trading partners. 36 The entry condition (2) can be rewritten as (1−1/H)qA = w /[(1−δ)Z ], and a similar condition t t t holds in foreign. When H rises, other things given, the value of productive units in home is above the entry cost. Entry occurs to the point that restores equality through the implied e(cid:27)ects on qA and w . There is t t no need for such entry in foreign, as the deregulation shock has no impact on the entry condition there that requires adjustment on the entry margin. This intuition does not apply to the transition dynamics with international borrowing and lending below. In that case, resource shifting across countries implies an e(cid:27)ect of the deregulation shock on foreign wages that requires reduced entry(cid:22)and therefore a lower number of foreign tradable producers(cid:22)for some time to restore equality to the entry condition during the transition. Consistent with the intuition, the shock has no long-run e(cid:27)ect on foreign entry. In Ghironi and Melitz (2005), endogenous tradedness is responsible for a small adjustment in the number of foreign producers under (cid:28)nancial autarky. 15

bias in preferences for tradables rather than non-traded goods. To conclude this section, we quantify the direct welfare e(cid:27)ects of banking deregulation (abstracting from its implications for the business cycle) by computing the percentage increase ∆ in consumption that would leave the representative household in each country indi(cid:27)erent between alternative banking regulation regimes. Denote with CSBM the (symmetric) steady-state level of consumption when bank markets are segmented across di(cid:27)erent locations within each country, and let CD and CD∗ be the consumption levels in the two t t countries following banking deregulation at home. Time subscripts in CD and CD∗ capture t t the presence of transition dynamics following deregulation, which we assume to be implemented at time t = 0. The consumption equivalent ∆ is obtained by solving the following equation: (cid:88) ∞ u (cid:2)(cid:0) 1+ ∆ (cid:1) CSBM) (cid:3) βtu(CD) = 100 , t 1−β t=0 and similarly abroad. As shown in Table 3, home banking deregulation improves welfare in both countries. Quantitatively, welfare gains are signi(cid:28)cantly larger at home (1.15 percent of pre-deregulation steady-state consumption, approximately ten times as abroad). We obtain a similar result in the model with home bias (see the Appendix). 5 International Deposits We now extend the model of the previous section to allow households to hold deposits 37 abroad. We study how international deposits a(cid:27)ect the results we have previously described and how microeconomic dynamics a(cid:27)ect the current account in our model. Since the extension to international deposits does not involve especially innovative features relative to the (cid:28)nancial autarky setup, we limit ourselves to describing its main ingredients in words here and present the relevant model equations in the Appendix. We assume that banks can supply deposits domestically and internationally. Home deposits, issued to home and foreign households, are denominated in home currency. Foreign deposits, issued to home and foreign households, are denominated in foreign currency. We maintain the assumption that nominal returns are indexed to in(cid:29)ation in each country, so that deposits issued by each country provide a risk-free return measured in units of that country’s consumption basket. International asset markets are incomplete, as only risk-free deposits are traded across countries. We assume that agents must pay quadratic transaction fees to banks when adjusting their deposits abroad. Banks then rebate the revenues from deposit adjustment fees to households. These fees pin down a unique deterministic steadystate allocation of deposits with zero net foreign assets and ensure stationary responses of the model to non-permanent shocks. Since agents pay fees only when they adjust their de- 37 For simplicity, we continue to assume that banks are owned only domestically. International trade in bankequitywouldenhanceinternationalrisksharinginthemodel,astotaldividendpaymentstohouseholds would become contingent on productivity abroad. The same would happen if we allowed for cross-country bank lending. The assumption that entrants must borrow from domestic banks is quite plausible for small (cid:28)rms (as we noted above, a large portion of U.S. GDP). This assumption implies that, even if international depositsgiveborrowers(indirect)accesstoforeignsavings,thenumberofdomesticbanksrepresentedineach locality remains the relevant measure of bank monopoly power. To evaluate the consequences of enhanced international risk sharing, we discuss some properties of the complete markets allocation below. de Blas and Russ (2013), Mandelman (2010), and Niepmann (2012, 2013) study the consequences of richer forms of cross-border banking. 16

posits abroad, the steady state of the model with international deposits coincides with the steady state of the model under (cid:28)nancial autarky. In particular, β(1+r) = β(1+r∗) = 1, B = B∗ = wN /Z, and B = B∗ = 0, where B (B∗) is home (foreign) holdings of home ∗ E ∗ ∗ (foreign) deposits, B (B∗) is home (foreign) holdings of foreign (home) deposits, and we ∗ assumed Z = Z∗. Realistic parameter values imply that the cost of adjusting deposits has a very small impact on model dynamics, other than pinning down the deterministic steady 38 state and ensuring mean reversion in the long run when shocks are transitory. In equilibrium, the markets for home and foreign deposits clear, and each country’s net foreign assets entering period t+1 depend on interest income from deposit holdings entering periodt, laborincome, netinvestmentincome, andconsumptionduringperiodt. Thechange innetforeigndepositholdingsbetweentandt+1isthecountry’scurrentaccount. Homeand foreigncurrentaccountsaddtozerowhenexpressedinunitsofthesameconsumptionbasket. There are now three Euler equations in each country: the Euler equation for share holdings, which is unchanged, and Euler equations for holdings of domestic and foreign deposits. Euler equations for deposits in each country imply a no-arbitrage condition between domestic and foreign deposits. The balanced trade condition closed the model under (cid:28)nancial autarky. Since trade is no longer balanced with international deposits, we must explicitly impose labor market clearing conditions in both countries. These conditions state that the amount of labor used in production and to cover entry costs in each country must equal labor supply in that country in each period. As before, we analyze the response path of the real exchange rate and other key variables to a permanent banking deregulation. We set the scale parameter for the deposit adjustment cost, η, to 0.0025(cid:22)su(cid:30)cient to generate stationarity in response to transitory shocks (such as the productivity shocks we will consider below), but small enough to avoid overstating the role of this friction in determining the dynamics of our model. Interstate Banking and Macroeconomic Dynamics under Incomplete Markets As under (cid:28)nancial autarky, we consider the responses to a deregulation of home banking (a permanent increase in the number of home banks, H) such that the number of home producers increases by 12 percent in the long-run. Figure 2 shows the results. To save space, we do not discuss the behavior of bank markups, pro(cid:28)ts, share prices, and the value of (cid:28)rms to the bank in this scenario. Most responses are qualitatively similar to Figure 1. Initially, households in both countries reduce consumption to (cid:28)nance increased producer entry in the deregulated home economy. Home runs current account de(cid:28)cits for approximately two years in response to the shock, resulting in the accumulation of a persistent net foreign debt position. Home households borrow from abroad to (cid:28)nance higher initial investment (relative to (cid:28)nancial autarky) in new home (cid:28)rms. The home household’s incentive to front-load producer entry is mirrored by the foreign household’s desire to invest in the more attractive economy. Although home consumption declines initially, it is permanently higher in the long run. Foreign consumption moves by more than in Figure 1 as foreign households 38 DevereuxandSutherland(2010)andTilleandvanWincoop(2010)developanalternativetechniquefor pinning down steady-state international asset portfolios. We use a convenient speci(cid:28)cation of adjustment costs to pin down the steady-state allocation of deposits and ensure stationarity since our interest is in the dynamics of overall net foreign assets rather than the composition of portfolios. Moreover, we are interested in evaluating how international deposits a(cid:27)ect dynamics around the same steady state as under (cid:28)nancial autarky, while the Devereux-Sutherland/Tille-van Wincoop technique would imply a di(cid:27)erent steady state. See Hamano (2014) for an application of this technique to a model with extensive margin dynamics. 17

initially save in the form of foreign lending and then receive income from their positive asset position. Although foreign households cannot hold shares in the mutual fund of home banks (since deposits are the only international (cid:28)nancial asset), the return on deposit holdings is tied to the return on holdings of shares in home banks by no-arbitrage between deposits and shares within the home economy. Therefore, foreign households share the bene(cid:28)ts of expansion in the home economy via international deposit holdings. As in the case of (cid:28)nancial autarky, TOL must decrease in the long run (home e(cid:27)ective labor must relatively t appreciate); otherwise, all new entrants would choose to locate in the home economy. The accelerated entry of new home (cid:28)rms (cid:28)nanced by external borrowing induces an immediate relative increase in home labor demand, and TOL immediately appreciates (as opposed t to a gradual appreciation under (cid:28)nancial autarky). Thus, the real exchange rate Q also t 39 immediately appreciates. The opening of the economy to international deposits does not qualitatively change the mechanism that leads to real exchange rate appreciation following banking deregulation in our model. Foreign consumption and GDP increase in the long run, even though the number of foreign producers is reduced by the relocation of business creation to the home country. Higher income and the permanent expansion in the number of home producers more than compensates the loss in the number of foreign (cid:28)rms to determine the increase in long-run foreign consumption. Finally, as under (cid:28)nancial autarky, banking deregulation in one country improves welfare in both countries (see Table 3). The Role of Market Incompleteness Before turning to two model extensions that deliver more persistent current account de(cid:28)cits, we brie(cid:29)y discuss the role of market incompleteness for our results. We present selected (cid:28)gures in the Appendix. Marketincompletenessinteractswithsubstitutabilitybetweendomesticandforeignproducts to determine the extent of international borrowing and lending. High substitutability and internationally complete asset markets strengthen the incentive and ability to shift resources toward the home economy to (cid:28)nance the investment expansion in new products triggered by bank deregulation. With complete markets, this transfer of resources is not encoded in history dependence of the equilibrium allocation, and net foreign assets are determined residually. With incomplete markets, the equilibrium allocation depends on the net foreign assets position at the beginning of each period. Under both scenarios, external borrowing(cid:22)the transfer of resources in response to deregulation(cid:22)increases with the share of tradables in consumption or, in the model with home bias, with the extent to which preferences are biased toward domestic goods. In both cases, the stronger incentive of home households to invest in creation of new domestic products drives the result. The e(cid:27)ects of tradable share and home bias are consistent with the analysis in Corsetti, Dedola, and Leduc 40 (2008). Withrespecttointernationalrelativeprices, expansioninthenumberofproducersresults in appreciation of the terms of labor, improvement of the terms of trade, and appreciation of the data-consistent real exchange rate in response to banking deregulation under both 39 Thetermsoflaborandtherealexchangerateovershoottheirnewlong-runappreciatedlevelsonimpact, re(cid:29)ecting the e(cid:27)ect on home labor costs of the spike in labor demand from increased business creation on impact. 40 Substitutabilitybetweenhomeandforeigngoodsisconstrainedtobestrictlylargerthan1inourmodel, inwhichwedonotdi(cid:27)erentiatebetweencross-countryandwithin-countrysubstitutability. Thispreventsus from analyzing the low substitutability scenarios studied by Corsetti, Dedola, and Leduc (2008). 18

complete and incomplete markets. (The welfare-consistent real exchange rate depreciates in the long run in the model with home bias.) A larger tradable share or home bias parameter ampli(cid:28)es the appreciation of the data-consistent real exchange rate by inducing larger expansion in home product creation. Persistent Current Account De(cid:28)cits Figure 2 shows that the home country runs current account de(cid:28)cits for two years following the banking deregulation. U.S. current account de(cid:28)cits have been longer lasting in the 1980s and 1990s. However, it is easy to extend our model to generate more persistent de(cid:28)cits while preserving the other key results. For instance, the current account de(cid:28)cit is signi(cid:28)cantly more persistent if the banking deregulation is treated as an anticipated, rather than unanticipated, event. This is a plausible scenario, considering the legislative process required by the deregulation. Figure 3 presents the results when the deregulation is expected to happen two years in the future. As the (cid:28)gure shows, the home country starts borrowing immediately, to (cid:28)nance increased business creation in anticipation of the coming deregulation, and the current account de(cid:28)cit lasts for three years. Another way to increase current account persistence is to assume that the entry cost depends on the number of existing (cid:28)rms as in Grossman and Helpman (1991). Suppose that creating a new (cid:28)rm requires (N )λ units of e(cid:27)ective labor. When λ < 0, there is t a positive externality from the number of existing (cid:28)rms to entry costs. The intuition is that product creation is easier in an environment where there has been much creation in 41 the past. Figure 4 presents the responses to (unanticipated) banking deregulation in this scenario, with λ = −0.5 for illustrative purposes. This version of the model results in a signi(cid:28)cantly more persistent de(cid:28)cit, lasting approximately eight years. Since current entry reduces future entry costs, the incentive to borrow to (cid:28)nance (cid:28)rm creation is strengthened, and this propagates the de(cid:28)cit over time. We have thus established two consequences of lower local monopoly power of banks: real exchange rate appreciation and external borrowing to (cid:28)nance increased business creation. Next, we turn to a more quantitative version of our model to study the consequences of interstate banking for macroeconomic volatility. 6 Interstate Banking and International Business Cycles We now extend the model with international deposits to incorporate countercyclical (cid:28)rm markups and elastic labor supply. Assuming that (cid:29)uctuations in home and foreign productivity are the sources of international business cycles, this allows us to illustrate the mechanism behind the moderation of business cycle volatility generated by interstate banking in our model. This extension exploits the implications of endogenous variety by allowing for endogenous demand elasticity and countercyclical (cid:28)rm markups. The representative home household now supplies L units of labor endogenously in each t period. The household maximizes expected intertemporal utility from consumption and labor e(cid:27)ort subject to the same budget constraint as in the previous section. Expected (cid:104) (cid:105) intertemporal utility is E (cid:80)∞ βs−t logC −χ(L )1+1/ϕ/(1+1/ϕ) , where χ > 0 is the t s=t s s weight of disutility of labor e(cid:27)ort, and ϕ > 0 is the Frisch elasticity of labor supply to wages. 41 This is the case on which Grossman and Helpman (1991) focus in their analysis of endogenous growth. 19

The household’s intertemporal optimality conditions remain the same. The only additional optimality condition is the intratemporal optimality condition for labor supply. Elastic labor supply implies that households have an extra margin of adjustment to shocks. This enhances thepropagationmechanismofthemodelbyamplifyingtheresponsesofendogenousvariables with respect to the benchmark model. To generate endogenously (cid:29)uctuating markups, we now de(cid:28)ne the baskets of goods over 42 discrete numbers of home and foreign varieties. The basket of tradable goods now is C = (cid:0)(cid:80) c (ω)(θ−1)/θ (cid:1)θ/(θ−1) ; hence, P = (cid:0)(cid:80) p (ω)1−θ (cid:1)1/(1−θ) . Each producer no T,t ω∈Ω t T,t ω∈Ωt t longer ignores the e(cid:27)ects of its nominal domestic price, p (ω), on the home tradable price D,t index, P , and the e(cid:27)ect of its nominal export price, p (ω), on the foreign tradable price T,t X,t (cid:104) (cid:105) index, P∗ . 43 Home demand elasticity is then θ (ω) ≡ θ 1−(p (ω)/P )1−θ and foreign T,t D,t D,t T,t (cid:104) (cid:105) demand elasticity is θ (ω) ≡ θ 1− (cid:0) p (ω)/P∗ (cid:1)1−θ . Note that taking into account this X,t X,t T,t indirect price e(cid:27)ect decreases the demand elasticities for (cid:28)rm ω: θ (ω) < θ and θ (ω) < θ; D,t X,t hence, it increases its monopoly power in both markets. The implied markup is µ (ω) ≡ D,t θ (ω)/(θ (ω)−1) in the domestic market and µ (ω) ≡ θ (ω)/(θ (ω)−1) in the for- D,t D,t X,t X,t X,t eign market. Firms set (cid:29)exible prices that re(cid:29)ect these di(cid:27)erent markups over marginal cost 44 in the di(cid:27)erent markets where they sell their output. As before, de(cid:28)ne the relative prices ρ (ω) ≡ p (ω)/P , ρ ≡ P /P , ρ (ω) ≡ p (ω)/P∗ , and ρ∗ ≡ P∗ /P∗. Then, D,t D,t T,t T,t T,t t X,t X,t T,t T,t T,t t ρ (ω) = (ρ )−1µ (ω)w /Z and ρ (ω) = (cid:0) ρ∗ (cid:1)−1 τQ−1µ (ω)w /Z . Pro(cid:28)ts generated D,t T,t D,t t t X,t T,t t X,t t t by domestic sales are d (ω) = α(ρ (ω))1−θC /θ (ω), and pro(cid:28)ts generated by exports D,t D,t t D,t are d (ω) = αQ (ρ (ω))1−θC∗/θ (ω). Since all (cid:28)rms are identical in equilibrium, we X,t t X,t t X,t drop the index ω below. In this version of the model, banks internalize the e(cid:27)ect of entry on (cid:28)rm pro(cid:28)ts through the e(cid:27)ect of entry on the nominal domestic price, p , and then on the home tradable price D,t index, P , and the e(cid:27)ect of entry on the nominal export price, p , and then on the foreign T,t X,t tradable price index, P∗ . The equation for (cid:28)rm value, q , becomes: T,t t (cid:40) (cid:41) (cid:18) C (cid:19)−1(cid:20)(cid:18) 1 θ (cid:19) (cid:18) 1 θ (cid:19) (cid:21) t+1 q = βE 1− d + 1− d +(1−δ)q . t t D,t+1 X,t+1 t+1 C H θ H θ t D,t+1 X,t+1 (6) (Derivation details are in the Appendix. A similar equation holds abroad. This equation holds also in the model with home bias.) As in the benchmark model, equation (6) implies that there is no entry at the extreme H = 1 of absolute bank monopoly: The return from funding an entrant is negative in this case, as the portfolio expansion e(cid:27)ect is dominated by pro(cid:28)t destruction (recall that θ < θ and θ < θ). Bank monopoly power decreases as D,t+1 X,t+1 H increases, and equation (6) simpli(cid:28)es to the familiar asset pricing equation with perfectly competitive asset pricing at the other extreme, H = ∞. Over the business cycle generated 42 An alternative way to generate endogenously (cid:29)uctuating markups would be to use translog preferences with a continuum of producers as in Bilbiie, Ghironi, and Melitz (2012). Since both speci(cid:28)cations result in countercyclical markups, we conjecture that results would be similar for our purposes. 43 See Yang and Heijdra (1993) for an analysis of Dixit-Stiglitz monopolistic competition with a discrete number of producers. 44 Weimplicitlyassumethat(cid:28)rmshavetheabilitytosegmentmarkets,sothatconsumerscannotarbitrage away deviations from the law of one price in excess of those implied by trade costs. Since (cid:28)rm entry is procyclical in our model, markups are countercyclical, and their movements amplify (cid:29)uctuations in (cid:28)rm output. 20

by an increase in productivity, as the number of (cid:28)rms increases, the demand elasticities θ D,t and θ increase, and markups fall. On the one hand, the fact that the ratios θ/θ and X,t D,t+1 θ/θ arelargerthanonereducesbankincentivestoinvestinnew(cid:28)rms. Ontheotherhand, X,t+1 since (cid:28)rm pro(cid:28)ts are procyclical and banks own claims to these pro(cid:28)ts, the importance of the pro(cid:28)t destruction externality falls as θ/θ and θ/θ decrease, strengthening bank D,t+1 X,t+1 incentives to invest. Table 2 summarizes the main equilibrium conditions of this version of the model (showing 45 only the equations pertaining to home variables and net foreign assets). We study the model predictions with Frisch elasticity ϕ = 10. 46 We set the weight of the disutility of labor, χ, to 1. In this and the following section, we set the share of tradable goods in the consumption basket, α, to 0.5, while iceberg trade costs are kept at τ = τ∗ = 1.33. The choice of α is dictated by di(cid:30)culties in computing the model’s steady state, and it implies a steady-state import share of about 18 percent. 47 The other preference parameters, and the size of the exogenous exit probability δ, remain the same as in the benchmark model. The calibration strategy for H is the same as before. We set the pre-deregulation H to imply a 10 percent bank markup. Then, a 12 percent long-run increase in the number of domestic (cid:28)rms pins down the size of the increase in H that captures banking deregulation. We keep the steady-state home and foreign productivity levels, Z and Z∗, at 1. Note that, in this version of the model, this choice not only determines the number of (cid:28)rms (the size of the economy ) in steady state, and hence the steady-state (cid:28)rm markups, but it also matters for the cyclical properties of markups. The lower steady-state productivity, the lower the number of (cid:28)rms, andthehighersteady-state(cid:28)rmmarkups. Inturn, thisimpliesmorecountercyclicalmarkups overthebusinesscycle. Theintuitionissimple: Whenthesteady-statenumberof(cid:28)rmsislow (so that each of them is operating on a larger share of the market), banks have an incentive to (cid:28)nance more entry (as a percentage of the initial steady state) following a favorable productivity shock than when the steady-state number of (cid:28)rms is large. As a consequence, the markup falls by more (in percent of the initial steady state) when expansions happen around a steady state with a smaller number of (cid:28)rms. This e(cid:27)ect is mirrored by household labor supply decisions. By adjusting steady-state productivity, we can a(cid:27)ect the interplay of wealth and substitution e(cid:27)ects in labor supply. As lower steady-state productivity leads to more countercyclical markups, and hence more procyclical wages, it generates stronger substitution e(cid:27)ects and weaker wealth e(cid:27)ects in labor supply in the impact response to temporary productivity shocks. For persistent enough shocks, the representative household then is willing to take advantage of temporarily high productivity by supplying more labor to increase substantially the available number of products, lower (cid:28)rm monopoly power, and experience signi(cid:28)cantly higher consumption in the later portion of the transition. The Responses to Banking Deregulation Figure 5 shows the responses to home banking deregulation. Time varying (cid:28)rm markups and elastic labor supply result in ampli(cid:28)ed responses of endogenous variables. Consistent 45 Note that ρ∗ = (ρ )−1Q τ∗µ∗ w∗/Z∗, and hence a foreign (cid:28)rm earns export pro(cid:28)ts d∗ = X,t T,t t X,t t t X,t αQ−1(cid:0) ρ∗ (cid:1)1−θ C /θ∗ . t X,t t X,t 46 The case in which ϕ → ∞ corresponds to linear disutility of e(cid:27)ort and is often studied in the business cycle literature. 47 The lowest steady-state import share we obtained with τ = τ∗ = 1.33 was 16 percent with α approximately 0.35. 21

with a reduction in monopoly power in the economy, home labor supply is permanently higher. Since households can now respond to the shock also by expanding their labor e(cid:27)ort, and (cid:28)rm markups decline, home consumption no longer falls on impact. Similarly, the response of foreign labor allows the foreign economy to enjoy increased business creation and GDP. As in the model with inelastic labor and constant (cid:28)rm markups, the terms of labor appreciate, leading to real exchange rate appreciation, and the home economy borrows 48 to (cid:28)nance increased business creation. Productivity Shocks and Macroeconomic Dynamics Figure 6 illustrates the business cycle propagation properties of our model by showing the impulse responses to a transitory increase in home productivity. We assume a 1 percent innovation to home productivity with persistence 0.9. The solid lines are the impulse responses around the pre-deregulation steady state, while dashes denote impulse responses around the post-deregulation steady state. As the (cid:28)gure shows, the shock has no permanent e(cid:27)ect since all endogenous variables are stationary in response to stationary exogenous shocks. However, the responses also clearly highlight the substantial persistence of key endogenous variables(cid:22) well beyond the exogenous persistence of the productivity shock. For example, it takes over ten years for the real exchange rate to return to the steady-state level. Note the initial appreciation of the terms of labor, again motivated by the e(cid:27)ect of increased entry of new (cid:28)rms into the home economy on home labor costs. Since shock persistence is relatively low (by real business cycle standards), lending abroad to smooth the consequences of a temporary, favorable shock on consumption is the main determinant of net foreign asset dynamics, and the home economy runs a current account surplus for most 49 of the (cid:28)rst four years, accumulating net foreign assets above the steady state. While the value of additional (cid:28)rms to the bank rises as the economy expands, positive productivityshocksareassociatedwithlowerdomesticbankmarkupsand(forsomequarters) 50 declining bank pro(cid:28)ts. Even if individual (cid:28)rm pro(cid:28)ts fall below the steady state quickly, expansion of the loan portfolio causes bank pro(cid:28)ts to recover and remain above the steady 48 As in the model with inelastic labor supply and constant (cid:28)rm markups, assuming that the transition to interstate banking is anticipated or introducing an externality in entry costs increases the persistence of the current account de(cid:28)cit. Figures for these cases are available on request. 49 When the shock is more persistent, (cid:28)nancing increased (cid:28)rm entry in the more productive economy becomesthemaindeterminantofthecurrentaccount,andthehomeeconomyrunsade(cid:28)citinresponsetohigher productivity. Theprocyclicalityofentrythatcharacterizesourmodelisstronglysupportedempirically. The NBER Working Paper version of Bilbiie, Ghironi, and Melitz (2012) documents a contemporaneous correlation between U.S. GDP and net entry (measured as the di(cid:27)erence between new incorporations and failures) equal to 0.4. See Bilbiie, Ghironi, and Melitz (2012) and references therein for additional discussion of the evidence of strong procyclicality of entry (and relative acyclicality of exit) at plant and product levels. Our model yields a contemporaneous correlation between GDP and entry equal to 0.72 for the benchmark calibration. Ifourgoalweretomatchthecorrelationabove, itwouldbeeasytoaccomplishthatbyintroducing adjustment costs that delay entry in the model without altering our main conclusions. 50 The literature on bank dynamics convincingly documents the countercyclicality of various measures of bank margins (often measured by net interest margins) and markups. See, for instance, Aliaga-D(cid:237)az and Olivero(2010,2011),CorbaeandD’Erasmo(2011),andMandelman(2011). Aliaga-D(cid:237)azandOliveroreport numbersapproximatelybetween−0.20and−0.35forthecontemporaneouscorrelationofU.S.bankmargins with GDP (per capita) at quarterly frequency. Corbae and D’Erasmo (cid:28)nd a correlation of approximately −0.50 between bank markups and GDP at annual frequency. Our model and benchmark calibration generate a correlation of bank markup with GDP at −0.83 for the benchmark markup measure (−0.90 for the alternative)bothbeforeandafterthederegulation. Although, themodeloverstatesthecountercyclicalityof the bank markup, we view the qualitative result as a success. 22

state for a substantial portion of the transition. As a consequence, share prices in home banks rise above the steady state for approximately (cid:28)ve years. The return to home bank share holdings also rises on impact. As for the responses to banking deregulation, increased producer entry causes the terms of labor to appreciate. This results in an impact, small appreciation of the real exchange rate. However, this is quickly reversed: The number of home tradable producers increases enough relative to foreign that the second term in equation (5) becomes the key driver of exchange rate dynamics, as home households save on trade costs (for some time) over an increasing portion of their consumption basket. Importantly, lower bank monopoly power implies a smaller percent deviation of (cid:28)rm entry from the steady state, less countercyclical (cid:28)rm markups, and weaker substitution e(cid:27)ects in labor supply. As a consequence of deregulation, the responses of (cid:28)rm entry, labor supply, consumption, investment in new products, and aggregate output are muted in the home economy. Given the trade and (cid:28)nancial ties with home, banking deregulation at home results in dampened (cid:29)uctuations also abroad. The intuition is straightforward, and related to the discussion of the consequences of changes in steady-state productivity above. Post-deregulation, the economy is populated by a larger steady-state number of (cid:28)rms, which are operating on a smaller share of the market and charging lower markups due to higher elasticity of demand. As a consequence, when a favorable productivity shock happens, the banks’ incentive to let additional (cid:28)rms into the economy is weakened, and we observe less business creation as a percentage of the steady-state number of (cid:28)rms than around the pre-deregulation steady state. In turn, this dampens markup (cid:29)uctuations around the post-deregulation steady state, and it is accompanied by weaker substitution e(cid:27)ects in labor supply and muted responses of home and foreign 51 endogenous variables to the productivity shock. Deregulation and Moderation The model includes only one source of (cid:29)uctuations at business cycle frequency, the shocks to aggregate productivity Z and Z∗. Our interest is not in whether the model has the t t ability to replicate a wide range of data moments, but in studying the consequences of the transition to interstate U.S. banking for macroeconomic volatility through the channel discussed above. For this purpose, we assume that the percentage deviations of Z and t Z∗ from the steady state follow a bivariate process with persistence parameters φ and t Z φ , non-negative spillover parameters φ and φ , and normally distributed, zero-mean Z∗ ZZ∗ Z∗Z innovations. We consider two alternative calibrations for the productivity process. First, we use the symmetrized estimate of the bivariate productivity process for the United States and an aggregateofEuropeaneconomiesinBackus, Kehoe, andKydland(1992)andsetφ = φ = Z Z∗ 0.906 and φ = φ = 0.088. The latter value implies a small, positive productivity ZZ∗ Z∗Z spillover across countries, such that, if home productivity rises during period t, foreign productivity will also increase at t + 1. We set the standard deviation of the productivity innovations to 0.00852 (a 0.73 percent variance) and the correlation to 0.258 (corresponding to a 0.19 percent covariance) as estimated by Backus, Kehoe, and Kydland (1992). In the second parameterization, we follow Baxter (1995) and Baxter and Farr (2005), who argue for increased persistence and absence of spillovers, and we set the spillover parameters 51 WediscusstheroleofmarketincompletenessforthetransmissionofproductivityshocksintheAppendix. 23

φ = φ = 0 and persistence φ = φ = 0.995, leaving the variance-covariance matrix ZZ∗ Z∗Z Z Z∗ of innovations unchanged. We calculate the implied values of theoretical second moments of Hodrick-Prescott (HP)-(cid:28)ltered endogenous variables (percent deviations from steady state). As customary, we set the HP (cid:28)lter parameter λ = 1,600. We present second moments of data-consistent real variables computed by de(cid:29)ating nominal ones with data-consistent price indexes. These are obtained by removing pure variety e(cid:27)ects from the welfare-consistent price indexes as described in the Appendix. Denoting ˜ the data-consistent price index at home with P , data-consistent, real variables are obtained t as X ≡ X P /P ˜ , where X is any variable in units of the consumption basket. 52 As we R,t t t t t previously discussed, creation of new (cid:28)rms is the form taken by capital accumulation in our model, and the stock of (cid:28)rms represents the capital stock of the economy. The measure of (cid:16) (cid:17) (cid:16) (cid:17) investment in our model is therefore I = P w N / Z P ˜ and I∗ = P∗w∗N∗ / Z∗P ˜∗ . R,t t t E,t t t R,t t t E,t t t Table 4 presents model-generated standard deviations for key macroeconomic aggregates and the real exchange rate for both calibrations of the productivity process. (The Appendix presentsthecorrespondingtable forthemodelwith homebias. Mostresultsaresimilar.) Focus on the Backus-Kehoe-Kydland parameterization (cid:28)rst. The model generates less volatile 53 consumption and labor e(cid:27)ort than GDP. Clearly, there is excess volatility of investment(cid:22)a standard (cid:28)nding absent an adjustment cost of the type usually introduced in business cycle models. Eliminating productivity spillovers and increasing the persistence of shocks as in the Baxter parameterization reduces the volatility across all variables. Both parameterizations show that lower local monopoly power of banks reduces the volatility of home GDP (more so 54 under the Backus-Kehoe-Kydland parameterization). Firm-level output (cid:29)uctuations (not reported) are also less volatile following banking deregulation, consistent with the evidence in Correa and Suarez (2007). As suggested by Figure 6, banking deregulation moderates 55 the cycle across all relevant macroeconomic aggregates in the home country. Foreign GDP volatility also declines, while foreign consumption becomes somewhat more volatile. To conclude our analysis, we quantify the welfare e(cid:27)ects of banking deregulation due to the change in business cycle dynamics. Speci(cid:28)cally, for a given level of bank monopoly power in (cid:28)nancial intermediation (segmented banking, denoted with SB, or integrated banking, denoted with IB), we compute the percentage ∆ of steady-state consumption that would make householdsindi(cid:27)erentbetweenlivinginaworldwithuncertaintyandlivinginadeterministic world: (cid:88) ∞ u (cid:2)(cid:0) 1+ ∆ (cid:1) CSB,LSB) (cid:3) E βtu(Creg,Lreg) = 100 , 0 t t 1−β t=0 and similarly abroad, where reg denotes the level of bank market integration at home (reg = SB or IB). We compute welfare by using a second-order approximation to the policy functions. As shown in Table 3, moderation of (cid:29)uctuations around the post-deregulation steady state 52 Whilethedistinctionbetweenwelfare-anddata-consistentvariablesdoesnotmatterfortherealexchange rateinourmodelwithnon-tradedgoods,itmattersforvariablesthatarenotde(cid:28)nedascross-countryratios. 53 King and Rebelo (1999) document that the ratios of standard volatilities of consumption, labor e(cid:27)ort, and investment to GDP in U.S. data are 0.74, 0.99, and 2.93, respectively, over the sample they consider. 54 The volatility of U.S. GDP declined by approximately 30 percent during the Great Moderation. Our model explains between one-fourth and one-third of this reduction depending on the calibration of the productivity process. 55 Bank markup volatility also declines. 24

results in smaller welfare costs of business cycles in both countries. Notice, however, that the welfare gain through the business cycle e(cid:27)ect is small compared to the direct gains discussed above. This result is not surprising since welfare costs of business cycles in our model are already small when local monopoly power of banks is high. 7 Conclusion We developed a two-country model of the domestic and external e(cid:27)ects of removing national bank market segmentation that predicts real appreciation, external borrowing, and moderation of domestic and international business cycles as joint equilibrium consequences of increased local banking competition. The key channel through which this occurs is increased business creation in the deregulating economy relative to the rest of the world, as potential entrants in product markets have easier access to bank (cid:28)nance in the less segmented market. The model provides an explanation of features of U.S. and international macroeconomic dynamics following the transition to interstate U.S. banking that started in the late 1970s. This explanation complements those already studied in the literature. By focusing on the structure of banking, the reduction in the local monopoly power of banks implied by deregulation, and the incentives for producer entry, the model is consistent with a large body of evidence from the empirical (cid:28)nance literature. The mechanism we highlight is very robust. We focused on the e(cid:27)ects of the removal of geographical segmentation of bank markets, but any form of (cid:28)nancial market deregulation that facilitates access to (cid:28)nance by product market entrants would lead to real appreciation, external borrowing, and eventual business cycle moderation through the channels we discussed. In this respect, our model provides a lens through which one can look at the consequences of (cid:28)nancial deregulation more broadly de(cid:28)ned as any action that facilitates access to (cid:28)nance. Of course, one would want to extend the model to incorporate heterogeneous borrower quality, asymmetric information, risk of default, and other forms of market 56 regulation (or deregulation) to capture the crisis that began in 2007. Incorporation of within-country, idiosyncratic risk would also make it possible to confront the model with the empirical results of another strand of literature in (cid:28)nance, which documents that U.S. banking deregulation improved risk sharing across U.S. states by facilitating access to (cid:28)nance for small business owners (Demyanyk, (cid:216)stergaard, and Słrensen, 2007). We leave these extensions for future work, along with an exploration of optimal regulation policy and endogenous (cid:28)nancial market development. Acknowledgments This paper was circulated previously under the title (cid:16)The Domestic and International E(cid:27)ects of Financial Deregulation.(cid:17) First draft: July 21, 2007. For helpful comments, we thank Giancarlo Corsetti, two anonymous referees, Alessandro Barattieri, Rucha Bhate, Claudia Buch, Silvio Contessi, Mathias Ho(cid:27)mann, Michael Koetter, Guay Lim, Federico Mandelman, Alan 56 Note that one can view the decision to purchase a house as an entry decision (into home ownership) requiringasunkinvestmentofresourcesthatmust(forthemostpart)beborrowedfrombanks. Deregulation that makes access to this (cid:28)nance easier for households will result in more entry into home ownership and external borrowing. Household heterogeneity, asymmetric information, and debt default would then be necessaryadditionalingredientsforamodeloftherecentinternational(cid:28)nancialcrisisthatpreservesthekey logic of our model. 25

Sutherland, CØdric Tille, and conference and seminar participants at Atlanta Fed, Boston Fed (seminar and Dynare Conference 2008), Bundesbank Spring Conference 2010 (International Risk Sharing and Global Imbalances), ECB Financial Markets and Macroeconomic Stability Conference, Econometric Society NASM 2008, EEA 2008, ESEM 2009, Federal Reserve Board, HEC MontrØal, IMF, Kansas City Fed (System Conference on Macroeconomics 2008), LACEA 2008, MIT, NBER IFM Spring 2008, Paci(cid:28)c Rim Conference 2013, Reserve Bank of Australia 2007 Research Workshop on Monetary Policy in Open Economies, SED 2008, University of Connecticut, University of Houston, University of Maryland, University of Wisconsin-Madison, and Vanderbilt University. We are grateful to Alessandro Barattieri and Rucha Bhate for outstanding research assistance. All remaining errors are ours. Ghironi thanks the NSF for (cid:28)nancial support through a grant to the NBER. Work on this paper was done while Ghironi was a Visiting Scholar at the Federal Reserve Bank of Boston. The support of this institution is also acknowledged with gratitude. The views presented in this paper are solely of the authors and do not necessarily represent the views or policy of the CEPR, the Federal Reserve Bank of Boston, the Federal Reserve Board, or the NBER. 26

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Table 1. Benchmark Model, Summary 1 = (ρ )α(ρ )1−α T,t N,t Consumption price indexes 1 = (cid:0) ρ∗ (cid:1)α(cid:0) ρ∗ (cid:1)1−α T,t N,t 1 = N (ρ )1−θ +N∗ (cid:0) ρ∗ (cid:1)1−θ Tradable price indexes t D,t t X,t 1 = N∗ (cid:0) ρ∗ (cid:1)1−θ +N (ρ )1−θ t D,t t X,t ρ = (ρ )−1µw /Z D,t T,t t t Good prices, domestic market ρ∗ = (cid:0) ρ∗ (cid:1)−1 µw∗/Z∗ D,t T,t t t ρ = (cid:0) ρ∗ (cid:1)−1 τQ−1µw /Z Good prices, export market X,t T,t t t t ρ∗ = (ρ )−1τ∗Q µw∗/Z∗ X,t T,t t t t ρ = w /Z N,t t t Good prices, non-tradable ρ∗ = w∗/Z∗ N,t t t d = α(ρ )1−θC /θ+αQ (ρ )1−θC∗/θ Firm pro(cid:28)ts t D,t t t X,t t d∗ = α (cid:0) ρ∗ (cid:1)1−θ C∗/θ+αQ−1 (cid:0) ρ∗ (cid:1)1−θ C /θ t D,t t t X,t t π = d N −(1+r )B Bank pro(cid:28)ts t t t t t π∗ = d∗N∗ −(1+r∗)B∗ t t t t t q = w /[(1−δ)Z ] Firm entry t t t q∗ = w∗/[(1−δ)Z∗] t t t q = βE (cid:8) (C /C )−γ[(1−1/H)d +(1−δ)q ] (cid:9) t t t+1 t t+1 t+1 Firm value q∗ = βE (cid:110) (cid:0) C∗ /C∗ (cid:1)−γ(cid:2) (1−1/H∗)d∗ +(1−δ)q∗ (cid:3) (cid:111) t t t+1 t t+1 t+1 N = (1−δ)(N +N ) t+1 t E,t Number of (cid:28)rms N∗ = (1−δ)(N∗ +N∗ ) t+1 t E,t 1 = β(1+r )E (cid:2) (C /C )−γ(cid:3) t+1 t t+1 t Euler equation, deposits 1 = β (cid:0) 1+r∗ (cid:1) E (cid:104) (cid:0) C∗ /C∗ (cid:1)−γ (cid:105) t+1 t t+1 t v = βE (cid:2) (C /C )−γ(v +π ) (cid:3) t t t+1 t t+1 t+1 Euler equation, shares v∗ = βE (cid:104) (cid:0) C∗ /C∗ (cid:1)−γ(cid:0) v∗ +π∗ (cid:1) (cid:105) t t t+1 t t+1 t+1 B = (w /Z )N t+1 t t E,t Deposit market clearing B∗ = (w∗/Z∗)N∗ t+1 t t E,t C +B = d N +w L Aggregate accounting t t+1 t t t C∗ +B∗ = d∗N∗ +w∗L∗ t t+1 t t t Balanced trade Q N (ρ )1−θC∗ = N∗ (cid:0) ρ∗ (cid:1)1−θ C t t X,t t t X,t t 31

Table 2. Quantitative Model, Summary Consumption price index 1 = (ρ )α(ρ )1−α T,t N,t Tradable price index N (ρ )1−θ +N∗ (cid:0) ρ∗ (cid:1)1−θ = 1 t D,t t X,t (cid:104) (cid:105) Demand elasticity, home market θ = θ 1−(ρ )1−θ D,t D,t (cid:16) (cid:17) Good prices, home market ρ = (ρ )−1 θD,t wt D,t T,t θD,t−1 Zt (cid:104) (cid:105) Demand elasticity, export market θ = θ 1−(ρ )1−θ X,t X,t (cid:16) (cid:17) Good prices, export market ρ = (cid:0) ρ∗ (cid:1)−1 τQ−1 θX,t wt X,t T,t t θX,t−1 Zt Good prices, non-tradable ρ = wt N,t Zt Firm pro(cid:28)ts, home market d = α (ρ )1−θC D,t θD,t D,t t Firm pro(cid:28)ts, export market d = α Q (ρ )1−θC∗ X,t θX,t t X,t t Bank pro(cid:28)ts π = (d +d )N −(1+r )(B +B∗) t D,t X,t t t t t Firm entry q = w /[(1−δ)Z ] t t t   (cid:16) (cid:17)   1− 1 θ d  Firm value q t = βE t     (cid:16) C C t+ t 1 (cid:17)−1   + (cid:16) 1− H H 1 θD θX ,t+ , θ t+ 1 1 (cid:17) d D X ,t+ ,t+ 1 1         +(1−δ)q  t+1 Number of (cid:28)rms N = (1−δ)(N +N ) t t−1 E,t−1 Euler equation, domestic deposits 1 = β(1+r )E (cid:2) (C /C )−1(cid:3) t+1 t t+1 t Euler equation, deposits abroad 1+ηB = β (cid:0) 1+r∗ (cid:1) E (cid:2) (Q /Q )(C /C )−γ(cid:3) ∗,t t+1 t t+1 t t+1 t Euler equation (shares) v = βE (cid:2) (C /C )−γ(v +π ) (cid:3) t t t+1 t t+1 t+1 Deposit market clearing B +B∗ = (W /Z )N t+1 t+1 t t E,t Labor supply χ(L )1/ϕ = w (C )−γ t t t (cid:16) (cid:17) Labor market clearing L = θD,t−1d + θX,t−1d N + NE,t + 1−α Ct t wt D,t wt X,t t Zt Zt ρN,t Net foreign assets Q B −B∗ = Q (1+r∗)B −(1+r )B∗ t ∗,t+1 t+1 t t ∗,t t t +1 (w −Q w∗)+ 1 (d N −Q d∗N∗) 2 t t t (cid:16)2 t t t t t (cid:17) −1 (C −Q C∗)− 1 wtN −Q w t ∗ N∗ 2 t t t 2 Zt E,t tZ t ∗ E,t 32

Table 3. Welfare E(cid:27)ects of Deregulation Direct E(cid:27)ect1 Home Foreign ∆W: Financial Autarky 1.15% 0.09% ∆W: International Deposits, 1.17% 0.07% Inelastic Labor, and Fixed Markups ∆W: International Deposits, 1.23% 0.10% Elastic Labor, and Fixed Markups ∆W: International Deposits, 2.46% 0.29% Elastic Labor, and Time-Varying Markups Business Cycle E(cid:27)ect2 Home Foreign ∆W: Backus-Kehoe-Kydland Calibration 0.003% 0.001% ∆W: Baxter Calibration 0.003% 0.001% 1Welfare calculations include transition dynamics. 2We report results only for the model with international deposits, elastic labor, and time-varying markups. A positive welfare change denotes a reduction in the welfare costs of business cycle following deregulation. 33

Table 4. Standard Deviations Before and After Deregulation Backus-Keohe-Kydland Calibration Before After % Change Y 6.4767 5.7779 -10.79 R Y∗ 6.4767 5.9629 -7.93 R C 1.1890 1.0479 -11.87 R C∗ 1.1890 1.2201 2.62 R I 126.62 104.31 -17.62 R I∗ 126.62 116.63 -7.89 R L 5.1940 4.7461 -8.62 L∗ 5.1940 4.7827 -7.92 Baxter Calibration Before After % Change Y 1.9105 1.7984 -5.87 R Y∗ 1.9105 1.8135 -5.08 R C 1.1673 1.1047 -5.36 R C∗ 1.1673 1.1859 1.59 R I 24.826 19.9587 -19.61 R I∗ 24.826 23.0943 -6.98 R L 0.8625 0.8013 -7.10 L∗ 0.8625 0.7558 -12.37 34

)LOT( robaL fo smreT )*N( smriF fo rebmuN F )N( smriF fo rebmuN H )*C( noitpmusnoC F )C( noitpmusnoC H 0 1 51 2.0 2 1− 5.0 1.0 01 0 2− 0 0 5 2− 3− 5.0− 1.0− 4− 1− 0 2.0− 4− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )Q( etaR egnahcxE laeR )*d( stiforP mriF F )d( stiforP mriF H )*Y( PDG F )Y( PDG H 0 2.0 0 2.0 2 1.0 1.0 1− 5− 1 0 0 2− 01− 0 1.0− 1.0− 3− 2.0− 51− 2.0− 1− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )Er( serahS ot nruteR H )*q( knaB ot eulaV mriF F )q( knaB ot eulaV mriF H )* B μ( pukraM knaB F ) B μ( pukraM knaB H 06 2.0 2 0 01− 1.0 5.1 1.0− 04 21− 0 1 2.0− 02 41− 1.0− 5.0 3.0− 0 2.0− 0 4.0− 61− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )*Er( serahS ot nruteR F )*v( ecirP erahS knaB F )v( ecirP erahS knaB H )*π( stiforP knaB F )π( stiforP knaB H 3 2.0 2− 2.0 0 1.0 1.0 2 4− 01− 0 0 1 6− 02− 1.0− 1.0− 0 2.0− 8− 2.0− 03− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 ykratuA laicnaniF rednu noitalugereD gniknaB .1 erugiF 35

)LOT( robaL fo smreT )*N( smriF fo rebmuN F )N( smriF fo rebmuN H )*C( noitpmusnoC F )C( noitpmusnoC H 4.3− 0 02 2 2 6.3− 1− 01 0 0 8.3− 2− 0 2− 2− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )Q( etaR egnahcxE laeR )*d( stiforP mriF F )d( stiforP mriF H )*Y( PDG F )Y( PDG H 2− 5 5− 2.0 2 5.2− 01− 0 0 3− 0 51− 2.0− 2− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )AC( tnuoccA tnerruC )*q( knaB ot eulaV mriF F )q( knaB ot eulaV mriF H )* B μ( pukraM knaB F ) B μ( pukraM knaB H 5 5.0 2 5 41− 0 0 1 0 51− 5− 5.0− 0 5− 61− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )A( stessA ngieroF teN )*v( ecirP erahS knaB F )v( ecirP erahS knaB H )*π( stiforP knaB F )π( stiforP knaB H 0 2 0 02 0 02− 5− 0 5− 0 04− 01− 2− 01− 02− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )*Er( serahS ot nruteR F )Er( serahS ot nruteR H 02 05 0 02− 0 04 03 02 01 04 03 02 01 stisopeD lanoitanretnI htiw noitalugereD gniknaB .2 erugiF 36

)LOT( robaL fo smreT )*N( smriF fo rebmuN F )N( smriF fo rebmuN H )*C( noitpmusnoC F )C( noitpmusnoC H 0 0 02 1 2 2− 1− 01 0 0 4− 2− 0 1− 2− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )Q( etaR egnahcxE laeR )*d( stiforP mriF F )d( stiforP mriF H )*Y( PDG F )Y( PDG H 1− 4 0 2.0 2 2− 2 5− 0 0 3− 0 01− 2.0− 2− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )AC( tnuoccA tnerruC )*q( knaB ot eulaV mriF F )q( knaB ot eulaV mriF H )* B μ( pukraM knaB F ) B μ( pukraM knaB H 1 5.0 2 5 0 0 0 1 0 01− 1− 5.0− 0 5− 02− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )A( stessA ngieroF teN )*v( ecirP erahS knaB F )v( ecirP erahS knaB H )*π( stiforP knaB F )π( stiforP knaB H 0 1 2− 0 0 5− 0 4− 02− 02− 01− 1− 6− 04− 04− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )*Er( serahS ot nruteR F )Er( serahS ot nruteR H 02 05 0 0 02− 05− 04 03 02 01 04 03 02 01 stisopeD lanoitanretnI htiw noitalugereD gniknaB detapicitnA .3 erugiF 37

)LOT( robaL fo smreT )*N( smriF fo rebmuN F )N( smriF fo rebmuN H )*C( noitpmusnoC F )C( noitpmusnoC H 0 1 02 5.0 2 2− 0 01 0 1 4− 1− 0 5.0− 0 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 )Q( etaR egnahcxE laeR )*d( stiforP mriF F )d( stiforP mriF H )*Y( PDG F )Y( PDG H 0 1 0 1.0 2 1− 5.0 01− 0 0 2− 0 02− 1.0− 2− 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 )AC( tnuoccA tnerruC )*q( knaB ot eulaV mriF F )q( knaB ot eulaV mriF H )* B μ( pukraM knaB F ) B μ( pukraM knaB H 5.0 5.0 01 1 0 0 0 0 0 2− 5.0− 5.0− 01− 1− 4− 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 )A( stessA ngieroF teN )*v( ecirP erahS knaB F )v( ecirP erahS knaB H )*π( stiforP knaB F )π( stiforP knaB H 0 5.0 2 1 5 01− 0 0 0 0 02− 5.0− 2− 1− 5− 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 052 002 051 001 05 )*Er( serahS ot nruteR F )Er( serahS ot nruteR H 2 1 0 5.0 2− 0 052 002 051 001 05 052 002 051 001 05 tsoC yrtnE nampleH-namssorG ,stisopeD lanoitanretnI htiw noitalugereD gniknaB .4 erugiF 38

)LOT( robaL fo smreT )*N( smriF fo rebmuN F )N( smriF fo rebmuN H )*C( noitpmusnoC F )C( noitpmusnoC H 5.5− 2 02 2 5 6− 0 01 0 5.6− 2− 0 2− 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )Q( etaR egnahcxE laeR )*Y( PDG F )Y( PDG H )*L( robaL F )L( robaL H 0 5 6 5 01 2− 0 5 0 5 4− 5− 4 5− 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )AC( tnuoccA tnerruC )* B μ( pukraM knaB F ) B μ( pukraM knaB H )*d( stiforP mriF F )d( stiforP mriF H 5 5 32− 01 0 0 0 42− 0 01− 5− 5− 52− 01− 02− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )A( stessA ngieroF teN )*π( stiforP knaB F )π( stiforP knaB H )*q( knaB ot eulaV mriF F )q( knaB ot eulaV mriF H 0 01 0 2 5 01− 0 05− 0 02− 01− 001− 2− 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )*Er( serahS ot nruteR F )Er( serahS ot nruteR H )*v( ecirP erahS knaB F )v( ecirP erahS knaB H 001 001 0 5− 05 0 2− 01− 0 001− 4− 51− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 spukraM mriF suonegodnE dna robaL citsalE htiw noitalugereD gniknaB .5 erugiF 39

)LOT( robaL fo smreT )*N( smriF fo rebmuN F )N( smriF fo rebmuN H )*C( noitpmusnoC F )C( noitpmusnoC H 0 2 6 52.0 4 2.0 1 2.0− 2 0 − 0 2 1 5 . 1 0 .0 5.0 4.0− 50.0 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )Q( etaR egnahcxE laeR )*Y( PDG F )Y( PDG H )*L( robaL F )L( robaL H 1 4.0 4 4 2.0 0 0 2 2 0 1− 1− 2.0− 2− 0 2− 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )AC( tnuoccA tnerruC )* B μ( pukraM knaB F ) B μ( pukraM knaB H )*d( stiforP mriF F )d( stiforP mriF H 2 1 0 5.0 0 2− 1 0 0 4− 1− 5.0− 0 1− 6− 1− 2− 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )A( stessA ngieroF teN )*π( stiforP knaB F )π( stiforP knaB H )*q( knaB ot eulaV mriF F )q( knaB ot eulaV mriF H 51 01 0 2.0 1 01 5 01− 1.0 5.0 5 0 02− 0 0 5− 03− 1.0− 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 )*Er( serahS ot nruteR F )Er( serahS ot nruteR H )*v( ecirP erahS knaB F )v( ecirP erahS knaB H 01 04 6.0 5.1 4.0 5 02 1 2.0 5.0 0 0 0 0 04 03 02 01 04 03 02 01 04 03 02 01 04 03 02 01 noitalugereD-tsoP dna -erP ,selcyC ssenisuB .6 erugiF 40