This dissertation consists of four essays that investigate the economic consequences of frictions in credit markets and the implications for macroprudential and monetary policies. The first essay addresses the following question: How do excessive debt holdings on borrower balance sheets impede economic activity? To address this question, we estimate a non-linear panel threshold model on a large-scale panel data set for euro area non-financial corporates. We account for non-linearities in the debt-investment link and find that excessive corporate leverage negatively affects firm investment if the debt-to-asset ratio exceeds 80 to 85 percent. These non-linearities are economically meaningful and robust across firm size, sector, and profitability, and were aggravated during the European sovereign debt crisis. The second and third essay address the following questions: How does the presence of unregulated shadow banks affect credit markets and the economy? What implications follow for prudential regulation and monetary policy? In the second essay, we develop a quantitative New Keynesian DSGE model for the euro area and estimate the model with full-information Bayesian techniques. We show that changes in bank capital requirements lead to credit leakage between shadow and commercial banks, and that monetary policy can partly mitigate undesired leakage to the shadow banking sector when banking regulation is tightened. In the third essay, I turn to the optimal design of macroprudential regulation when credit is intermediated by traditional banks and unregulated shadow banks. I derive welfare loss functions and show that both cyclical variations and inefficient levels of credit have welfare implications. Regulators face a trade-off related to the composition of credit when deciding on optimal regulation. I find that they lower capital requirements more strongly under optimal policy in response to adverse shocks that trigger credit leakage to risky non-banks. Furthermore, the optimal static level of capital requirements is lower once shadow banks are considered. In the fourth essay, we address the following question: How much do market participants gain from a European Deposit Insurance Scheme (EDIS)? To this end, we develop an open-economy regime-switching DSGE model with bank default and study the effectiveness of EDIS in comparison to national fiscal policies. We find that reinsurance by both national fiscal policy and EDIS is effective in stabilizing the macro economy, even though welfare gains are slightly larger with EDIS and debt-to-GDP ratios rise under fiscal policy reinsurance. We demonstrate that risk-weighted contribution to EDIS are welfare-beneficial and discuss policy trade-offs during the implementation of EDIS.
