Q&A: Seven Questions on Financial Frictions and the Sources of Business Cycle

• Author: Marzie Taheri Sanjani
• Pages: 13-15

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December 2014

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Financial friction s explicitly displayed in mac-

roeconomic models can improve our under-

standing of the driving forces of the bu siness

cycle. Frictions , through the presence of infor-

mation asymmetry, impose a non-z ero counter-

cyclical spread between l ending and borrowing,

which then amplify the role of financ ial shocks.

Question 1. What are the driving sources of the

business cycle?

Following the semina l work of Kydland and Prescott

(1982), the conventional view about the source s of the busi-

ness cycle has been centered main ly on technology shocks

(or total factor productivity (TFP)). Aer the experience

of the recent nancial cr isis, the view regarding the dr iv-

ing forces of the business cycle tu rned toward investment

channels. In line w ith this idea, Justiniano, Pr imiceri, and

Tambalotti (2010) argue that a more promising theory is one

that attributes uctu ations largely to investment shocks, and

more specically to ma rginal eciency of investment (MEI)

shocks. MEI shocks a re exogenous disturbances that aect

the eciency of the process t hat transforms current invest-

ment goods to future productive capital . Furthermore, it is

also argued t hat this shock is highly correlated wit h credit

spread. To corroborate the relationship between investment

shocks and the spread, we need a fr amework that explicitly

allows for a nancial i ntermediary sector and captures t he

interaction between ma rginal eciency of investment and

the spread. Taheri Sanjani (2014) extends the Gertler and

Karadi (2011) model by incorporating investment shocks; a

variance decomposition ana lysis shows that nancial shocks

are the main dr iving force behind the volatilities in p ost-war

U.S. macroeconomic data. e nancia l shock in Gertler

and Karadi (2011) are exogenous disturbances that aec t

the quality of capita l stock, and are highly correlated wit h

the credit spread. One policy i mplication can be that policy

which aects t he credit spread is the most eective instru-

ments for recovery during nancia l crises.

Question 2. How do the economic models with and

without financial frictions differ?

In a survey of nanc ial frictions by Brunnermeier and

others (2012), they explain a frictionless ec onomy as an

environment where funds are l iquid and can ow to the

most protable project; this model can b e presented with a

single representative agent and the agg regate output is only

the total capital a nd labor matter. In contrast, with nancial

frictions, liquid ity considerations become important and

the wealth dist ribution matters. is mechanism creates a

persistence and amplification eect . External nancing is

more costly when compared with inter nal funds and the

external na ncing depends on the return. Constra ins on

incentives, such as moral ha zard, result in leveraging as

productive agents issue, to a large extent, de bt to ensure that

the agent exerts sucient eort . However, debt claims come

with some severe drawback s: an adverse shock wipes out a

large fraction of the lever aged borrowers net worth, limiting

his risk-bearing capac ity in the future. Hence, a temporary

adverse shock is very persistent since it ca n take a long time

for productive agents to rebuild their net wort h through

retained earn ings. An initial shock is ampli ed if produc-

tive agents are forced to re-sell thei r capital. Since re-sales

depress the price of capital, the net wor th of productive

agents suers even fur ther (loss spiral). In addition, margins

and haircuts might r ise (while loan-to-value ratios m ight

fall) forcing productive agents to lower their leverage rat io

(margin spiral).

Question 3. What are the channels through which capital

quality shocks affect the economy?

In an economy without nancia l frictions, a negative shock

to the quality of capita l stock disturbs the capital accu mula-

tion dynamic, wh ich further deteriorates output moderately

due to the “time-to-build ” phenomenon. In the presence of

nancial fr ictions, negative capital quality shock a ects the

economy through an additiona l channel, namely, the bank

Seven Questions on Financial Frictions and the Sources of

Business Cycle

Marzie Taheri Sanjani

Q&A

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