Financial Accelerator Mechanism Research Articles

Total Social Finance: Mutual Influences between Financial Markets and Macro Economy

It was not until the outbreak of the global financial crisis in 2007 when people turned to Hyman Minsky's financial-instability hypothesis. Owing to the critique that financial markets are not taken into consideration in economic analyses, recent macroeconomic literature has started incorporating financial sectors in the models. This paper addresses this issue in a way that we extend a macroeconomic model to incorporate a standard agent-based model from the finance literature, aiming to investigate how the financial market and the real economy interact with each other. The boundedly rational investors derive the fundamental value of financial market by looking at the macroeconomic variables. Meanwhile, the financial market influences the price level through the wealth effect. Empirical investigation using US data shows that short-term interest rate decreases in corporate profit rate and increases in debt ratio, supporting the Minsky hypothesis and the financial accelerator mechanism respectively. We also find evidence of the mutual influence between the macroeconomic variables and the stock market. Moreover, our results provide some justification to the recent policy measure of the central bank of China -- total social finance which includes financial markets in measuring money supply.

International Business Cycle and Financial Frictions in Developing Countries

The economies of developing countries are increasingly connected with the rest of the world. This interconnection is not without consequence especially when one takes into account the characteristics peculiar to developing countries, such as the duality of economies and less developed financial systems. The objective of our research is to highlight the role of financial frictions facing by economic agents in developing countries in the mechanisms of international transmission of the business cycle. To do this, we develop a two-country stochastic general equilibrium model including informal sector. We are going to study the case of twenty two developing countries. The quarterly data coming from IMF, OCDE and national institutes of statistics. We will cover the range 1980Q1-2016Q4; estimation of our model will be done by the Bayesian method. As expected results, we believe that the liquidity constraints faced by consumers increase the volatility of consumption. We also believe that the constraints faced by entrepreneurs in both the formal and informal sectors amplify the spread of domestic and foreign shocks through the financial accelerator mechanism. The amplification is most important in informal sector than formal sector.

Asymmetric effects of the international transmission of US financial stress. A threshold-VAR approach

During period of financial stress, the effect of financial stress shocks on economic activity might be different from what is usually observed in normal times. This paper investigates the transmission of financial stress episodes on the macroeconomy during stressed and normal periods and it explores how these events are transmitted to the Eurozone. We find that, a detrimental US financial shock leads to a worsening in economic and financial conditions both domestically and in the Eurozone. In addition, during turmoil times, financial accelerator mechanism amplifies and propagates the transmission of US financial stress shocks to the Eurozone by reducing its economic activity. Moreover, small financial stress shocks, rather than infrequent large ones, are able to create large fluctuations in inflation rates. Last, the effect of a detrimental shock in financial conditions has larger negative effects in the economy compared with the positive effects that would be generated by a beneficial shock in financial conditions.

Understanding the Aggregate Effects of Credit Frictions and Uncertainty: Additional Results

This paper integrates a financial accelerator mechanism a la Bernanke et al. (1999) and time-varying uncertainty into a medium-scale Dynamic New Keynesian model. In our model, uncertainty emerges from monetary policy (policy uncertainty) as well as from financial risks (micro uncertainty) and the aggregate state of the economy (macro uncertainty). We describe the time-variant policy, micro and macro uncertainty using a stochastic volatility model. We use this framework to identify how uncertainty propagates and its interplay with financial frictions. We also investigate how uncertainty affects the propagation of other shocks (TFP, monetary policy shocks).

FX Intervention in the New Keynesian Model

We develop an open economy New Keynesian Model with foreign exchange intervention inthe presence of a financial accelerator mechanism. We obtain closed-form solutions for theoptimal interest rate policy and FX intervention under discretionary policy, in the face ofshocks to risk appetite in international capital markets. The solution shows that FXintervention can help reduce the volatility of the economy and mitigate the welfare lossesassociated with such shocks. We also show that, when the financial accelerator is strong, therisk of multiple equilibria (self-fulfilling currency and inflation movements) is high. Wedetermine the conditions under which indeterminacy can occur and highlight how the use ofFX intervention reinforces the central bank's credibility and limits the risk of multipleequilibria.

FX Intervention in the New Keynesian Model

We develop an open economy New Keynesian Model with foreign exchange intervention in the presence of a financial accelerator mechanism. We obtain closed-form solutions for the optimal interest rate policy and FX intervention under discretionary policy, in the face of shocks to risk appetite in international capital markets. The solution shows that FX intervention can help reduce the volatility of the economy and mitigate the welfare losses associated with such shocks. We also show that, when the financial accelerator is strong, the risk of multiple equilibria (self-fulfilling currency and inflation movements) is high. We determine the conditions under which indeterminacy can occur and highlight how the use of FX intervention reinforces the central bank’s credibility and limits the risk of multiple equilibria.

Understanding the Aggregate Effects of Credit Frictions and Uncertainty

This paper integrates a financial accelerator mechanism a la Bernanke et al. (1999) and time-varying uncertainty into a Dynamic New Keynesian model. We examine the extent to which uncertainty and credit conditions interact with one another. The idea is that uncertainty aggravates the information asymmetry between lenders and borrowers, and worsens credit conditions. Already poor credit conditions amplify the effect of shocks (to both the mean and variance) on the aggregate economy. In our model, uncertainty modelled as time-varying stochastic volatility emerges from monetary policy (policy uncertainty), financial risks (micro-uncertainty), and the aggregate state of the economy (macro-uncertainty). Using a third order approximation, we find that micro-uncertainty has first order effects on economic activity through its direct impact on credit conditions. We also find that if credit conditions (as measured by the endogenous risk spread) are already poor, then additional micro-uncertainty shocks have even larger real effects. In turn, shocks to aggregate uncertainty (macro- and policy-uncertainty) have relatively small direct effects on aggregate economic activity.

Policy, Risk and Spillover Analysis in the World Economy: A Panel Dynamic Stochastic General Equilibrium Approach

This paper develops a structural macroeconometric model of the world economy, disaggregated into forty national economies, to facilitate multilaterally consistent macrofinancial policy, risk and spillover analysis. This panel dynamic stochastic general equilibrium model features a range of nominal and real rigidities, extensive macrofinancial linkages, and diverse spillover transmission channels. These macrofinancial linkages encompass bank and capital market based financial intermediation, with financial accelerator mechanisms linked to the values of the housing and physical capital stocks. A variety of monetary policy analysis, fiscal policy analysis, macroprudential policy analysis, spillover analysis, and forecasting applications of the estimated model are demonstrated. These include quantifying the monetary, fiscal and macroprudential transmission mechanisms, accounting for business cycle fluctuations, and generating relatively accurate forecasts of inflation and output growth.

Uncertainty Shocks and Firm Dynamics: Search and Monitoring in the Credit Market

We develop a business cycle model where endogenous firm creation stems from two credit market frictions. First, entrepreneurs search for a lending relationship with a bank. Second, an optimal debt contract with monitoring is implemented. We analyze the interplay between both frictions, and embed it into an otherwise standard business cycle model, which we estimate with Bayesian techniques. We find that uncertainty shocks are a prime contributor to business cycle fluctuations in the US, not only for macro-financial aggregates but also for firm creation. Moreover, we point out that the credit search friction dampens the financial accelerator mechanism because default may imply the end of the lending relationship.

Time-Varying Volatility, Financial Intermediation and Monetary Policy

We document that expansionary monetary policy shocks are less effective at stimulating output and investment in periods of high volatility compared to periods of low volatility, using a regime-switching vector autoregression. Exogenous policy changes are identified by adapting an external instruments approach to the non-linear model. The lower effectiveness of monetary policy can be linked to weaker responses of credit costs, suggesting a financial accelerator mechanism that is weaker in high volatility periods. To rationalize our robust empirical results, we use a macroeconomic model in which financial intermediaries endogenously choose their capital structure. In the model, the leverage choice of banks depends on the volatility of aggregate shocks. In low volatility periods, financial intermediaries lever up, which makes their balance sheets more sensitive to aggregate shocks and the financial accelerator more effective. On the contrary, in high volatility periods banks decrease leverage, which renders the financial accelerator less effective; this in turn decreases the ability of monetary policy to improve funding conditions and credit supply, and thereby to stimulate the economy. Hence, we provide a novel explanation for the non-linear effects of monetary stimuli observed in the data, linking the effectiveness of monetary policy to the procyclicality of leverage.

The implications of financial frictions and imperfect knowledge in the estimated DSGE model of the U.S. economy

In this paper, I study how alternative assumptions about expectation formation can modify the implications of financial frictions for the real economy. I incorporate a financial accelerator mechanism into a version of the Smets and Wouters (2007) DSGE framework and explore the properties of the model assuming, on the one hand, complete rationality of expectations and, alternatively, several learning algorithms that differ in terms of the information set used by agents to produce the forecasts. I show that the implications of the financial accelerator for the business cycle may vary depending on the approach to modeling the expectations. The results suggest that the learning scheme based on small forecasting functions is able to amplify the effects of financial frictions relative to the model with Rational Expectations. Specifically, I show that the dynamics of real variables under learning is driven to a significant extent by the time variation of agents’ beliefs about financial sector variables. During periods when agents perceive asset prices as being relatively more persistent, financial shocks lead to more pronounced macroeconomic outcomes. The amplification effect rises as financial frictions become more severe. At the same time, a learning specification in which agents use more information to generate predictions produces very different asset price and investment dynamics. In such a framework, learning cannot significantly alter the real effects of financial frictions implied by the Rational Expectations model.

Macroprudential Regulation, Credit Spreads and the Role of Monetary Policy

We study the macroprudential roles of bank capital regulation and monetary policy in a borrowing cost channel model with endogenous financial frictions, driven by credit risk, bank losses and bank capital costs. These frictions induce financial accelerator mechanisms and motivate the examination of a macroprudential toolkit. Following credit shocks, countercyclical regulation is more effective than monetary policy in promoting price, financial and macroeconomic stability. For supply shocks, combining macroprudential regulation with a stronger anti-inflationary policy stance is optimal. The findings emphasize the importance of the Basel III accords in alleviating the output-inflation trade-off faced by central banks, and cast doubt on the desirability of conventional (and unconventional) Taylor rules during periods of financial distress.

Macroprudential regulation, credit spreads and the role of monetary policy

We study the macroprudential roles of bank capital regulation and monetary policy in a borrowing cost channel model with endogenous financial frictions, driven by credit risk, bank losses and bank capital costs. These frictions induce financial accelerator mechanisms and motivate the examination of a macroprudential toolkit. Following credit shocks, countercyclical regulation is more effective than monetary policy in promoting price, financial and macroeconomic stability. For supply shocks, combining macroprudential regulation with a stronger anti-inflationary policy stance is optimal. The findings emphasize the importance of the Basel III accords in alleviating the output-inflation trade-off faced by central banks, and cast doubt on the desirability of conventional (and unconventional) Taylor rules during periods of financial distress.

Exchange rate risks in a small open economy

PurposeThis study aims to analyze exchange rate risks and the choice of exchange rate policies in a small open economy indebted in foreign currency, incorporating the financial accelerator mechanism.Design/methodology/approachTo examine discussions on the fear of floating, this study develops a dynamic stochastic general equilibrium model in which a small open economy model has an open economy financial accelerator mechanism as the external borrowing restriction. The author then compares and analyzes the macroeconomic dynamics in response to an exchange rate shock under different exchange rate systems.FindingsThe most interesting finding is that the currency peg for a foreign currency used in borrowing is more efficient than the trade-weighted currency basket policy, regardless of trade openness or trade share.Practical implicationsThe result implies that in discussions on the fear of floating, more attention needs to be paid to exchange rate risks in finance. It also suggests that exchange rate policy used to mitigate exchange rate risks in finance stabilizes macroeconomic volatility more efficiently.Originality/valueThe paper provides an answer to the question: which is the more serious problem in the fear of floating and to what would the regime be anchored.

Credit constraints and the international propagation of US financial shocks

This paper investigates whether credit constraints in the US economy amplify the international propagation of US financial shocks. We model the dynamics of the US economy jointly with global macroeconomic and financial variables using a threshold vector autoregression. This model captures regime-specific dynamics conditional on the severity of credit constraints in the US economy. We identify three main episodes of tight credit in US financial history over the past thirty years. These occur in the late-1980s, in the early 2000s, and during the 2007–09 financial crisis. We find that US financial shocks are associated with a significant contraction in global economic activity in times of tight credit. By contrast, there is little impact of US financial shocks on the global economy in normal times. This asymmetry highlights an international dimension of the US financial accelerator mechanism.

Assessing Macro-Financial Linkages: A Model Comparison Exercise

The recent global financial crisis has increased interest in macroeconomic models that incorporate financial linkages. Here, we compare the simulation properties of five medium-sized general equilibrium models used in eurosystem central banks which incorporate such linkages. The financial frictions typically considered are the financial accelerator mechanism (convex 'spread' costs related to firms’ leverage ratios) and collateral constraints (based on asset values). The harmonized shocks we consider illustrate the workings and mechanisms underlying the financial-macro linkages embodied in the models. We also look at historical shock decompositions of real GDP growth across the models since 2005 in order to shed light on the common driving factors underlying the recent financial crisis. In these exercises, the models share qualitatively similar and interpretable features. This gives us confidence that we have some broad understanding of the mechanisms involved. In addition, we also survey the current and developing trends in the literature on financial frictions.

Optimal Monetary Policy in a Small Open Economy with Financial Frictions

I analyze how the introduction of financial frictions can affect the trade-off between output stabilization and inflation stability and whether, in the presence of financial frictions, the optimal outcome can be realized, or approached more closely, if monetary policy is allowed to react to aggregate financial variables. Moreover, I explore the issue of whether an inflation targeting cum exchange rate stabilization and a price-level targeting are more suitable rules in minimizing distortions generated by the presence of liabilities defined in foreign currency and in nominal terms. I find that, when the financial accelerator mechanism is working, a price-level targeting rule dominates. One caveat is that the source of the shock plays an important role. Once the financial shock is not operative, the gain from a price-level targeting rule decreases significantly.

Future Economic Information Embedded in High Yield Spreads

Future Economic Information Embedded in High Yield Spreads The financial accelerator mechanism, also called credit channel theory (Bernanke and Gertler [1995] and Bernanke and Gertler, and Gilchrist [1996]), assumes external financing is more costly than internal financing in the absence of full collateralization. The difference between external and internal costs is called “external finance premium” and arises from agency costs associated with asymmetric information about the firm’s net worth, defined as the sum of all liquid and illiquid assets minus debt. The external finance premium is inversely related to the firm’s net worth. Firms with poor credit are at the heart of the financial accelerator mechanism, and one can proxy for “external finance premium” using the spread paid by the poor-quality (high-yield) firms over the high-quality firms. In the parlance of the “financial accelerator mechanism,” a reduction of high-yield spread is the harbinger of future boom, and an increase in high-yield spread predicts a decline in economic activity. This article examines the significance of the spread variable to predict various economic variables. We control for momentum in the economic variable by including the four lagged quarters of the economic variable. We look at the growth rate of a broad spectrum of the economy; having tested the relationship between 84 economic measures and the four lagged measures of growth in high-yield spread, we report that 58 of the economic variables tested have statistically significant coefficients.

Monetary Policy and Large Crises in a Financial Accelerator Agent-Based Model

An accommodating monetary policy followed by a sudden increase of the short term interest rate often leads to a bubble burst and to an economic slowdown. Two examples are the Great Depression of 1929 and the Great Recession of 2008. Through the implementation of an Agent Based Model with a financial accelerator mechanism we are able to study the relationship between monetary policy and large scale crisis events. The main results can be summarized as follow: a) sudden and sharp increases of the policy rate can generate recessions; b) after a crisis, returning too soon and too quickly to a normal monetary policy regime can generate a double dip recession, while c) keeping the short term interest rate anchored to the zero lower bound in the short run can successfully avoid a further slowdown.

Time-Varying Volatility, Financial Intermediation and Monetary Policy

We document that expansionary monetary policy shocks are less effective at stimulating output and investment in periods of high volatility compared to periods of low volatility, using a regime-switching vector autoregression. Exogenous policy changes are identified by adapting an external instruments approach to the non-linear model. The lower effectiveness of monetary policy can be linked to weaker responses of credit costs, suggesting a financial accelerator mechanism that is weaker in high volatility periods. To rationalize our robust empirical results, we use a macroeconomic model in which financial intermediaries endogenously choose their capital structure. In the model, the leverage choice of banks depends on the volatility of aggregate shocks. In low volatility periods, financial intermediaries lever up, which makes their balance sheets more sensitive to aggregate shocks and the financial accelerator more effective. On the contrary, in high volatility periods, banks decrease leverage, which renders the financial accelerator less effective; this in turn decreases the ability of monetary policy to improve funding conditions and credit supply, and thereby to stimulate the economy. Hence, we provide a novel explanation for the non-linear effects of monetary stimuli observed in the data, linking the effectiveness of monetary policy to the procyclicality of leverage.