Money on the Sidelines? The Role of Costly Search and Weak Loan Demand in the Slow Recovery.

The Great Recession featured a large build-up of excess reserves by US banks. Money was sitting on the sidelines rather than being loaned. This paper explores how weak loan demand produced this phenomenon. I embed the New Keynesian model with novel financial frictions that slow the flow of bank funds to the private sector via a search and matching mechanism for long-term loans. Costly search generates a credit spread while imperfect matching produces an excess of liquid funds that banks divert to marketable securities in equilibrium. This structure generates a novel firm-level investment and loan search trade-off where these are complements during periods of high investment productivity and substitutes in response to financial shocks. Utilizing Bayesian estimation methods, I fit the DSGE model to both real and financial time series, adding marketable securities and a credit spread as observables. The model provides a rich business cycle narrative of the Great Recession as elucidated with model simulations. As in prior recessions, productivity contractions preceded the downturn, however, negative financial shocks then amplified the growth slowdown. The finnancial shocks quickly reverse and are followed by persistently low levels of investment efficiency, both in the contraction phase and the early recovery phase. That absence of good investment projects and wide credit spreads produced weak loan demand, consistent with bank-level surveys.