The Role of the Interbank Market in Business Cycles under Risk: A DSGE Approach

Document Type : Research Paper

Authors

Faculty of Economics, University of Allameh Tabataba'i, Tehran, Iran.

Abstract

This paper looks at how default risk shocks in the interbank market affect Iran’s business cycles, using a Dynamic Stochastic General Equilibrium (DSGE) model. We build on the model by Gerali et al. (2010), incorporating characteristics of the Iranian interbank market. The model is estimated using a Bayesian approach based on data from Iran. Our findings show that a drop in oil revenues, whether from falling global oil prices or increased sanctions, puts significant strain on the banking system’s liquidity. This pressure forces banks to rely on short-term liquidity management strategies like "rollovers." As a result, default risk rises and financial instability in the interbank market increases, leading to reduced access to bank credit, lower consumption, and declining production, which deepens the economic recession. The central bank’s open market operations play a key role in cushioning the impact of these shocks and managing liquidity, but they cannot fully restore normal market conditions. Overall, our study underscores the importance of effective risk management in the interbank market for maintaining macroeconomic stability

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References

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  • Receive Date: 25 January 2025
  • Accept Date: 04 May 2025

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