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Economics
Research insight
May 13, 2021

Essays on financial frictions

Abstract:

For the past forty years, the global economy has faced many challenges, including the increasing complexity and sophistication of financial markets, which created a new type of frictions that were in the origin of several recessive episodes such as the 2008 financial crisis. Such events were largely unexpected and much deeper than most theoretical macroeconomic models have predicted until that point, and the subsequent recovery was much slower. As a result, many macroeconomic models were heavily criticized for omitting key financial mechanisms and shocks stemming from the financial sector. To overcome this gap, a large number of studies that started characterizing the cyclical properties of financial variables such as the risk premium, firms' equity and debt flows at an aggregate level has proliferated exponentially during the last decades, as well as the diversity of different aspects of the financial sector that were conveniently modelized, such as the impact of credit supply conditions and borrowing constraints. Among that extensive plethora of macrofinancial models, emerged a cluster of authors devoted to analyze the role of financial frictions as a source of business cycle fluctuations. This thesis contributes to that branch of the literature in three different ways. Chapter 1 proposes a measure the welfare effects of financial shocks as a percentage of consumption in a real business cycle model and compare it with the welfare costs of a productivity shock. In this model firms use both equity and debt financing, and financial shocks are modelled as stochastic innovations in the probability to recover from the debt' liquidation value in case of default, as a result of a tightening of firms' financing conditions. The main results show that financial shocks explain a significant extent of the macroeconomic dynamics of real and financial variables observed during financial crises, including the events occurred during the recent 2008 financial recession. The findings also suggest that although the welfare costs imposed by financial shocks computed in this framework are small, their relevance as a source of disturbances in business cycles cannot be underestimated, since it is estimated that the welfare cost of a financial shock is approximately 4 times larger than the welfare cost of a standard productivity shock in the economy, assuming that there is a tax benefit over the gross interest rate and that there is an equity payout cost that represents the rigidities affecting the substitution between debt and equity. Chapter 2 establishes a comparison between the empirical time series of major macroeconomic aggregates during the period 1984Q1-2014Q2 with the simulated series computed from the Jermann and Quadrini (2012) model in terms of variability, persistence and amplitude of a productivity and a financial shocks, and between the respective impulse responses to each shock. The main goal is to infer if this model provides a solid theoretical framework capable of replicate and anticipate large and deep recessions caused by financial shocks, such as the 2008 financial crisis and subsequent Great Recession. I conclude that, despite being able to capture reasonably well the timing of the shocks and the consequent downfall of the real side of the economy that follows after the shock hits, the model is unable to replicate the magnitude, persistence and volatility found in the data. This paper also includes a brief survey which describes the sequence of events that led to the crash of the financial system in the U.S. in 2008 and characterizes the empirical behavior of financial and real variables during and after that period. Chapter 3 applies a New Keynesian DSGE model in which the nominal interest rate is determined according to a truncated Taylor rule and includes eight different shocks based on Jermann and Quadrini (2012) and Smets and Wouters (2007) to study the role of an interest rate subsidy as a fiscal instrument able to circumvent completely (or at least partially) the effects of a binding zero lower bound in the economy. This paper shows that, generally, the standard structural shocks such as preference and technological shocks are large enough to activate the zero lower bound constraint, as well as financial innovations. However, these findings also suggest that, during and after recession periods, when the zero lower bound binds, those shocks produce wider responses of output and the major macroeconomic aggregates than they would produce in an unconstrained economy, in terms of persistence and volatility. This paper also shows that by manipulating an interest rate tax subsidy to overcome the zero bound problem, it is possible to circumvent the zero lower bound completely, but at the cost of not achieving the first best allocation. I also quantify the tax benefit that would be sufficient to partially neutralize the effects of the zero lower bound constraint when different types of shocks affect the economy.

This PhD Dissertation was presented by Erica Marujo as part of the requirements for the Degree of Doctor of Philosophy in Economics. You can access the paper here.

Erica Marujo

Erica Marujo

Nova SBE PhD Alumna | Economist at Bank of Portugal

Website
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