The Distributional Effects of Bailouts

Abstract

This article examines the distributional effects of government bailouts using a heterogeneous agent New Keynesian model with financial intermediation frictions. We analyze government equity injections to financial institutions financed by debt issuance, capturing essential features of bailout policies during financial crises. When calibrated to match key features of the U.S. economy, bailout policies are expansionary and reduce inequality through general equilibrium effects operating primarily via aggregate demand stimulation and increased labor income rather than direct wealth effects. Equity injections increase the financial sector’s capacity to intermediate capital, leading to higher capital prices, increased investment, and substantial aggregate demand increases. This improves labor market conditions that benefit lower-income households more than wealth effects benefit the wealthy. The result is reduced wealth and consumption inequality, demonstrating that bailouts can simultaneously achieve macroeconomic stabilization and inequality reduction.

Introduction

The Global Financial Crisis of 2007–2008 prompted the U.S. government to purchase several hundred billion dollars in distressed assets from financial institutions. This intervention was authorized by the Emergency Economic Stabilization Act of 2008, which created the $700 billion Troubled Asset Relief Program to purchase toxic assets from banks. The idea of this massive intervention was controversial and faced backlash from the public and academia. Back-of-the-envelope calculations suggest that the cost per capita was more than $2,000. Discontent with the sluggish recovery and increasing wealth and income inequality, as documented by Perri and Steinberg (2012), gave rise to the advent of social movements such as OccupyWall Street. Strong opposition to bank bailouts and calls for more redistribution indicate that the disgruntled public perceived these issues as important, most likely because of their redistributive nature.

This article aims to shed light on the interaction of the contended bank bailout and inequality. We study this interaction using the framework developed in Chiang and Zoch (2023) and Chiang and Zoch (2025), which integrates a canonical heterogeneous agent New Keynesian (HANK) model with a frictional financial sector described by its asset supply system. The framework builds on HANK models (Kaplan, Moll, and Violante, 2018; Auclert, Rognlie, and Straub, 2024; Auclert et al., 2021), where rich household heterogeneity is a feature necessary to study the distributional effects of bailouts. The New Keynesian component contains the aggregate demand channel, which is crucial for aggregate outcomes. To appropriately capture the effect of bailing out the financial sector, it is important to pin down key features of the financial sector. We achieve this by calibrating the model to match the sufficient statistics in Chiang and Zoch (2023), which nests a large class of canonical models of financial frictions, such as Gertler and Karadi (2011), Bernanke, Gertler, and Gilchrist (1999), and Cúrdia and Woodford (2011). With key features of the financial frictions pinned down and the household and production sectors featuring a state-of-the-art HANK model, the framework is well-suited for quantitative policy experiments.