Effect of Financial Frictions on Monetary Policy Conduct: A Comparative Analysis of DSGE Models with and without Financial Frictions

Abstract

In this study, we explored the impact of bank leverage and financial frictions on the transmission of real and financial shocks. Two new Keynesian dynamic stochastic general equilibrium (DSGE) models, with and without financial frictions, were employed in the context of the Tunisian economy. In the analysis, we considered three types of shocks—productivity, monetary, and adverse bank capital shocks. The findings reveal that, in the model with financial frictions, the response of macroeconomic and financial variables to demand and supply shocks was more pronounced than in the baseline model, where frictions primarily exist at the borrower level. In this study, we underscored the significance of financial shocks, particularly negative bank capital shocks, in triggering substantial macroeconomic and financial fluctuations, especially when banks operate with higher leverage ratios. Additionally, the inclusion of financial frictions in the DSGE model enhanced its ability to capture the empirical features of real and financial shocks, providing valuable insights for effective monetary policymaking. The results provide foundational insights for Tunisian policymakers to assess the impact of financial frictions in the context of the Tunisian economy. This is significant for the Central Bank of Tunisia, which has not yet adopted a specific DSGE model. Therefore, through our analysis, we determined the amplificatory role of financial frictions in the dynamics of macroeconomic and financial variables in Tunisia and examined the main transmission channels of shock propagation.