Bank Leverage Cycles and the External Finance Premium

By combining the approaches of Gertler and Karadi (2011) (GK) and Bernanke, Gertler, and Gilchrist (1999) (BGG), I develop a Dynamic Stochastic General Equilibrium (DSGE) model with leverage constraints both in the banking and in the nonfinancial firm sector. I calibrate this full model to US data. The full model matches the relative volatility of the external finance premium and the procyclicality of bank leverage and thus outperforms both a BGG and a GK-type model. For a reasonably calibrated combination of balance sheet shocks, the model reproduces a substantial share of the contraction (increase) of investment (the external finance premium) observed during the Great Recession.