The Declining Power of US Monetary Policy
Chapter 3: Decreasing balance sheet constraints on financial firms
Financial institutions trade financial assets in addition to providing credit to households and firms. They are entities actively seeking profit by changing the size and composition of their balance sheets, subject to constraints determined by the institutional structure of the financial system in which they operate. In general, financial institutions can finance their own activities either by reshuffling their assets or borrowing in different forms. Reshuffling assets only changes the composition of their balance sheets without leading to an immediate expansion of their balance sheets. The expansion of the balance sheets of US financial institutions was relatively slow during the period from 1945 to 1980, but accelerated sharply in the 1980s. Even in the more recent period, however, financial institutions cannot expand their balance sheets arbitrarily. They still face some constraints. Understanding these balance sheet constraints is crucial to explaining the scale of balance sheet expansion in the US since the 1980s. This chapter develops a theoretical framework to investigate the implications of balance sheet constraints. It then presents a simulation exercise demonstrating how changes in balance sheet constraints combined with other inner forces within financial markets can affect the growth of balance sheets.
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