Financial intermediation, investment dynamics and business cycle fluctuations

Ajello, Andrea (2010): Financial intermediation, investment dynamics and business cycle fluctuations.

Abstract

How important are financial friction shocks in business cycles fluctuations? To answer this question, I use micro data to quantify key features of US financial markets. I then construct a dynamic equilibrium model that is consistent with these features and fit the model to business cycle data using Bayesian methods. In my micro data analysis, I establish facts that may be of independent interest. For example, I find that a substantial 35% of firm investment is funded using financial markets. The dynamic model introduces price and wage rigidities and a financial intermediation shock into Kiyotaki and Moore (2008). According to the estimated model, the financial intermediation shock explains around 35% of GDP and 60% of investment volatility. The estimation assigns such a large role to the financial shock for two reasons: (i) the shock is closely related to the interest rate spread, and this spread is strongly countercyclical and (ii) according to the model, the response in consumption, investment, employment and asset prices to a financial shock resembles the behavior of these variables over the business cycle.

• Item Type: MPRA Paper
• Language: English
• Keywords: DSGE model; Bayesian estimation; Financial frictions; Financial Shocks; Great Recession
• Subjects: D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D53 - Financial Markets; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C68 - Computable General Equilibrium Models; B - History of Economic Thought, Methodology, and Heterodox Approaches > B2 - History of Economic Thought since 1925 > B22 - Macroeconomics; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G0 - General > G01 - Financial Crises

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