Financial Frictions and Macroeconomic Fluctuations

Abstract

In this thesis, I assess the propagation power of financial rigidities, related to firm and bank financial health, and their impact on the fluctuations of external finance premium (efp) and on business cycles. The thesis is organized in four chapters.

The introductory chapter is a review of the literature related to the role of firm and bank financial health in general equilibrium models. The emphasis is on the most recent papers that are related to my thesis. In the second chapter, I empirically assess the relative significance of financial health of non-financial and financial sector for the external finance premium (efp) based on US and limited UK data using unrestricted vector autoregression (VAR). I also evaluate to what extent fundamental shocks like the total factor productivity (tfp), investment specific technology (ist) and monetary policy drive efp and output. The result that emerges from this analysis is that efp and
output are primarily driven by the tfp shocks and second by monetary policy shocks. In addition, financial sector net worth, rather than non-financial sector net worth, drives efp and output when fundamental shocks are absent.

In the third chapter, I set up a general equilibrium framework with two financial rigidities on firm and bank level to investigate the propagation of the fundamental shocks on efp and other macro and financial variables. Financial frictions are set-up as leverage constraints on borrower and lender in this framework (named FAGK).

To evaluate the propagation of shocks in each model I compare the second moments and impulse responses to those from a financial accelerator (FA) and a bank friction model (GK). Two main results come out. First, baseline FAGK model yields greater volatility of efp and of real variables, compared to FA or GK when driven by shocks of the same size. Second, the dynamics of overall efp are dominated by the fluctuations of the lender premium which is propagated
by the bank constraint in FAGK model. In the second part of the chapter, I evaluate how changes in the severity of frictions or in the conduct of monetary policy may lead to greater propagating power of shocks in the model economy.
The main conclusions are that, negligible policy response to output gap and a more persistent policy rate may contribute to greater propagating power of financial frictions.

In chapter 4, I estimate the baseline FAGK model and two single-friction models, FA and GK, employing Bayesian estimation method with quarterly data spanning 1955-2014. I assess the business cycle properties of each estimated model-economy and compare them to actual data. The baseline model can outperform the other two models, FA and GK, in describing the economy for the period.

To assess the stability of parameters I estimate the baseline FAGK model in two sub-samples, a tranquil sub-period, 1985-2004, and a recession period, 2005-2014. Next, I analyse the factors behind the increase in volatility during the recession period. Quantitative analysis based on counterfactual exercises leads me to conclude that the decline in investment adjustment cost and the increase in dispersion of returns across firms have shaped the business cycle properties of efp and of most indicators during the recession.