Financial Frictions, Financial Shocks, and Aggregate Volatility

Abstract

The Great Moderation in the U.S. economy was accompanied by a widespread increase in the volatility of financial variables. We explore the sources of the divergent patterns in volatilities by estimating a model with time-varying financial rigidities subject to structural breaks in the size of the exogenous processes and two institutional characteristics: the coefficients in the monetary policy rule and the severity of the financial rigidity at the steady state. To do so, we generalize the estimation methodology developed by Curdia and Finocchiaro (2013). Institutional changes are key in accounting for the volatility slowdown in real and nominal variables and in shaping the transmission mechanism of financial shocks. Our model accounts for the increase in the volatility of financial variables through larger financial shocks, but the vulnerability of the economy to these shocks is significantly alleviated by the estimated changes in institutions.