How do movements in the distributions of bank size and income affect the macroeconomy? To answer this question, we develop a dynamic general equilibrium model with heterogeneous financial intermediaries, incomplete markets, and aggregate uncertainty. We find that market incompleteness and uninsured idiosyncratic bank rate of return risk generate minimal concentration in the bank net worth distribution, leading to an “as-if” result, whereby the economy behaves as if it had a representative bank. However, introducing ex ante heterogeneity in the banks’ rates of return significantly raises concentration and amplifies real and financial fluctuations relative to the representative-bank case, as this increases a key sufficient statistic, the average marginal propensity to lend. We then extend the model with two empirically validated features of the banking sector—countercyclical return risk and deposit market power—and show that these amplify and dampen aggregate fluctuations, respectively. Finally, because in the model with ex ante heterogeneity the distribution of bank size is highly concentrated, shocks to the largest banks can account for almost all of the aggregate variation that is due to idiosyncratic risk, leading to granular banking and economic cycles. The failure of granular banks (“too big to fail”) produces sizeable macroeconomic crises.

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a simple representation in domestic inflation and the output gap. We use the resulting framework to analyse the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.