Degree Of Financial Frictions Research Articles

Dual-track interest rates and capital misallocation

The control-track interest rate and the market-track interest rate constitute China's dual-track interest rates. A theoretical model of dual-track interest rates and financial frictions is studied. In the model, bank loans are provided to state-owned enterprises with the control-track interest rate, private enterprises resort to shadow banking with the market-track interest rate. The interest rate wedge between these two interest rates distorts capital allocation, even driving a sector out of production. Full interest rate liberalization which eliminates the interest rate wedge alleviates cross-sector capital misallocation. However, the net effect on aggregate TFP is ambiguous due to the within-sector effect. Under calibrated parameters, full interest rate liberalization improves aggregate TFP moderately, unless the financial reform aimed to have SOEs and POEs face the same degree of financial frictions is also implemented.

Regime-Dependent Effects of Uncertainty Shocks: A Structural Interpretation

Using a Markov-switching VAR, we show that the effects of uncertainty shocks on output are four times higher in a regime of economic distress than in a tranquil regime. We then provide a structural interpretation of these facts. To do so, we develop a business cycle model, in which agents are aware of the possibility of regime changes when forming expectations. The model is estimated using a Bayesian minimum distance estimator that minimizes, over the set of structural parameters, the distance between the regime-switching VAR-based impulse response functions and those implied by the model. Our results point to changes in the degree of financial frictions. We discuss the implications of this structural interpretation and show that the expectation effect of regime switching in financial conditions is an important component of the financial accelerator mechanism. If agents hold pessimistic expectations about future financial conditions, then shocks are amplified and transmitted more rapidly to the economy.

Financial Development, Credit, and Business Cycles

How does financial development affect the magnitude of the business cycles fluctuations? We examine this question in a general equilibrium model with heterogeneous agents and endogenous credit constraints based on Kiyotaki (1998). We show that there is a hump-shaped relationship between the degree of financial frictions and the amplification of unexpected productivity shocks. This nonmonotonic relation is due to the fall in financial frictions having two opposite effects on the response of output. One effect is the reallocation of productive inputs between agent types, which, while active, increases with the fall in financial frictions. The other effect is the change in the demand of inputs, which decreases with the fall in financial frictions. At low levels of financial development, the reallocation effect dominates and a fall in financial frictions increases the amplification of productivity shocks. In contrast, at higher levels of financial development, a fall in financial frictions decreases the shock amplification because the reallocation effect disappears while the effect on the demand of inputs is still present.

Optimal Monetary Policy Rules and House Prices: The Role of Financial Frictions

We consider the scope for targeting house prices in simple monetary policy rules using a New Keynesian Dynamic Stochastic General Equilibrium model of the euro area with a housing sector and financial frictions on the household side. If the central bank’s main objective is the minimization of inflation and output fluctuations, then a systematic response to house prices does not entail any systematic sizeable welfare improvement. When the objective of monetary policy is the maximization of aggregate (and individual) welfare, then the optimized rule does feature a systematic reaction to house price variations. The sign and size of such reaction crucially depend on the degree of financial frictions in the economy. If the economy is characterized by both a large share of constrained agents and a high average loan-to-value ratio, then it is optimal to positively react to house price movements. Finally, we show that uncertainty about the actual degree of financial frictions suggests some caution in the construction of optimal monetary policy rules. The welfare costs generated by systematically counteracting house price movements are in general smaller than those implied by a procyclical response.

Optimal Monetary Policy Rules and House Prices: The Role of Financial Frictions

We probe the scope for reacting to house prices in simple and implementable monetary policy rules, using a New Keynesian model with a housing sector and financial frictions on the household side. We show that the social‐welfare‐maximizing monetary policy rule features a reaction to house price variations, when the latter are generated by housing demand or financial shocks. The sign and size of the reaction crucially depend on the degree of financial frictions in the economy. When the share of constrained agents is relatively small, the optimal reaction is negative, implying that the central bank must move the policy rate in the opposite direction with respect to house prices. However, when the economy is characterized by a sufficiently high average loan‐to‐value ratio, then it becomes optimal to counter house price increases by raising the policy rate.

Industrial specialization, financial integration and international consumption risk sharing

Standard models of international asset trade lack mechanisms linking an economy’s financial openness and industrial specialization. This paper presents a simple model of global portfolio diversification in which a link between financial liberalization and production specialization emerges very naturally. Within that model, an economy that liberalizes its financial markets is able to share its consumption risks, which in turn would allow the country to take extra risks in production by specializing in the good it produces more efficiently, resulting in higher output volatility and less correlated business cycles. The model provides insights about the effects of cross-country and cross-sector productivity shock correlations on portfolio choice, industrial specialization and consumption smoothing. Output volatility will increase as countries get more financially open, whereas consumption smoothing will depend on both the actual level of financial openness and on the productivity shock correlations between sectors and between countries. Higher integration induces greater production specialization, whereas the effect of productivity correlations on production diversification is ambiguous and depends on the degree of financial frictions.

Optimal Monetary Policy with Uncertainty About Financial Frictions

This paper studies optimal discretionary monetary policy in the presence of uncertainty about the degree of financial frictions. Changes in the degree of financial frictions are modelled as changes in parameters of a hybrid New-Keynesian model calibrated for the UK, following Bean, Larsen and Nikolov (2002). Uncertainty about the degree of financial frictions is modelled as Markov switching between regimes without and with strong financial frictions. Optimal monetary policy is determined for different scenarios of permanent and temporary regime shifts in financial frictions, as well as for variations in financial frictions over the business cycle. Optimal monetary policy is found to be state-dependent. In each state, optimal monetary policy depends on the transition probabilities between the different regimes.

FINANCIAL STRUCTURE, FIRMS’ INVESTMENTS AND THE CHANNELS OF MONETARY POLICY IN INDONESIA

Using Tobin’s q and Euler equations estimated by a novel technique of Blundell and Bond’s system MM, this paper investigate the role of financial factors (cash flow and leverage) in investment spending of Indonesian listed companies during 1993- 1997. Overall, the results suggest the existence of financial constraints and agency costs for Indonesian firms in raising external funds. However, agency costs vary across firms according to whether the firms are members of large business groups owning foreign exchange banks and their financial conditions (leverage and pay out ratio). These results provide indirect support to the existence of the credit channel of monetary policy which recently becomes a hot debate in the aftermath of the recent Asian financial crisis. A microeconomic aspects of both banks and firms. Specifically, the degree of financial frictions should be monitor using various indicators such as firms’ financial leverage, firms’ access to bank loans and bank’s willingness to lend.JEL Classification : E44, G31