Financial Intermediation and Business Cycles in Two-Period Lived OLG Models

This article investigates a two-period lived OLG model with financial intermediation as a vehicle to share risk. Risk-averse agents subject to idiosyncratic income shocks prefer financial intermediation that implements the efficient allocation to capital markets. It is shown that the resulting dynamics is monotonic and qualitatively the same as the dynamics of the classical OLG model by Diamond (1965). These results contradict Banerji, Bhattacharya, and Van Long (2004) by demonstrating that in two-period lived OLG models with rational expectations, financial intermediation that provides complete risk sharing can neither trigger business cycles nor complex dynamics. Business cycles can only occur if banks offer inefficient contracts