We introduce a banking sector and heterogeneous agents in the dynamic overlapping generations model of Matsuyama et al. (2016). Our model captures the benefits and costs of an advanced banking system. While it allocates resources to productive activities, it can also hinder progress if it invests in projects that do not contribute to capital formation, and potentially triggering instabilities due to the emergence of cycles. Our intergenerational dynamic framework enables us to show that income inequality between agents increases during recessions, confirming empirical observations. Moreover, we identify both changes in production factor prices and the reallocation of agents across occupations as driving factors behind the increased inequality.

I show that the defining features of the Great Moderation were a shift in output volatility toward medium-term fluctuations and a shift in the origin of those fluctuations from the real to the financial sector. I uncover a Granger-causal relationship whereby financial cycles attenuate short-term business cycle fluctuations while simultaneously amplifying longer-term fluctuations. As a result, financial shocks systematically drive medium-term output fluctuations, whereas real shocks drive short-term output fluctuations. I use these results to argue that the Great Moderation and Great Recession both resulted from the same economic forces. On the theoretical front, I show that long-run risk is a critical ingredient of DSGE models with financial sectors that seek to replicate these shifts. Finally, I use this DSGE model to refine the “good luck” and “good policy” hypotheses of the Great Moderation.