Costly intermediation, the big push and the big crash

Why does financial activity generate large real effects? We argue that this may reflect a multiplicity of equilibria, due to dynamic interactions between worker's saving decisions and bank's monopolistic competition. We show that the equilibrium-responses of key aggregates to changes in investment uncertainty and intermediation costs depend crucially on intertemporal substitutability and aggregate employment. Small financial disturbances may cause the economy to shift between low and high-employment equilibria, thus providing explanation for the big push and the big crash. The high-employment, high-real-interest-rate equilibrium is consistent with the development experience of the financially repressed East Asian economies prior to July 1997.