Firm leverage, household leverage and the business cycle

Solomon, Bernard Daniel (2010): Firm leverage, household leverage and the business cycle.

Abstract

This paper develops a macroeconomic model of the interaction between consumer debt and firm debt over the business cycle. I incorporate interest rate spreads generated by firm and household loan default risk into a real business cycle model. I estimate the model on US aggregate data. This allows me to analyse the quantitative importance of possible feedback effects between the debt levels of firms and households, and the relative contributions of financial and supply shocks to economic fluctuations. While firm level credit market frictions significantly amplify the response of investment to shocks, they do not amplify output responses. In general equilibrium, higher external financing spreads for households contribute to lower external financing spreads for firms, contrary to traditional Keynesian predictions. Furthermore, total factor productivity shocks remain an important source of business cycles in my model. They are responsible for 71 - 74% of the variance of output and 56 - 69% of the variance of consumption in the model. Financial shocks are important in explaining interest rate spreads and leverage ratios, but they account for less than 11% of the fluctuations in output. My results suggest that other factors, beyond credit market frictions on their own, are necessary to justify an important role for financial shocks in aggregate output fluctuations.

• Item Type: MPRA Paper
• Language: English
• Keywords: Financial frictions; external finance premium; DSGE models; Bayesian estimation; business cycles
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E21 - Consumption ; Saving ; Wealth; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C11 - Bayesian Analysis: General

References

[1] Tobias Adrian and Hyun Song Shin. Liquidity and leverage. working paper, 2008.

[2] Yann Algan, Olivier Allais, Wouter J. Den Haan, and Pontus Rendahl. Solving and simulating models with heterogeneous agents and aggregate uncertainty. working paper, 2009.

[3] Sungbae An and Frank Schorfheide. Bayesian analysis of dsge models. Econometric Reviews, 26:113�172, 2007.

[4] Martin Moller Andreasen. How to maximize the likelihood function for a dsge model. working paper, 2008.

[5] Kosuke Aoki, James Proudman, and Gerjan Vlieghe. House prices, consumption and monetary policy. Journal of Financial Intermediation, 13:414�435, 2004.

[6] Andrew Atkeson and Patrick J. Kehoe. Modeling the transition to a new economy: Lessons from two technological revolutions. The American Economic Review, 97(1):64� 88, March 2007.

[7] Robert J. Barro. Long term contracting, sticky prices, and monetary policy. Journal of Monetary Economics, 3:305�316, 1977.

[8] Susanto Basu and Miles Kimball. Long run labour supply and the elasticity of intertem- poral substitution for consumption. working paper, 2002.

[9] Ben Bernanke, Mark Gertler, and Simon Gilchrist. The �nancial accelerator in a quan- titative business cycle framework. Chapter in Handbook of Macroeconomics volume 1, 1999.

[10] Martin Browning and Jeremy Tobacman. Discounting and optimism equivalences. work- ing paper, 2007.

[11] Craig Burnside and Martin Eichenbaum. Factor hoarding and the propagation of busi- ness cycle shocks. American Economic Review, 86(5):1154�1174, 1996.

[12] Marco Cagetti. Wealth accumulation over the life cycle and precautionnary saving. Journal of Business, pages 1�15, July 2003.

[13] Jeffrey Campbell and Zvi Hercowitz. The role of collateralized household debt in macre- conomic stabilisation. working paper, 2006.

[14] Fabio Canova. Detrending and business cycle facts. Journal of Monetary Economics, 41:475�512, 1998.

[15] Charles Carlstrom and Timothy Fuerst. Agency costs, net worth, and business �uctu- ations: A computable general equilibrium analysis. The American Economic Review, 87(5):893�910, December 1997.

[16] Charles Carlstrom and Timothy Fuerst. Agency cost and business cycles. Economic Theory, 12:583�597, 1998.

[17] Christopher D. Carroll. Requiem for the representative consumer? aggregate implica- tions of microeconomic consumption behavior. working paper, 2000.

[18] Christopher D. Carroll. A theory of the consumption function, with and without liq- uidity constraints. working paper, 2001.

[19] Edouard Challe and Xavier Ragot. Precautionary saving in the business cycle. working paper, 2010.

[20] V.V Chari, Patrick J. Kehoe, and Ellen R. McGrattan. Business cycle accounting. Econometrica, 75:781�836, 2007.

[21] Raj Chetty. A new method of estimating risk aversion. American Economic Review, 96:1821�1834, 2006.

[22] Lawrence Christiano and Jonas Fisher. Stock market and investment good prices: im- plications for macroeconomics. working paper, 2003. [23] Lawrence Christiano, Roberto Motto, and Massimo Rostagno. Financial factors in economic �utuations. working paper, 2010.

[24] Francisco Covas and Wouter J. Den Haan. The role of debt and equity �nance over the business cycle. working paper, 2010.

[25] Matthieu Darrack-Paries, Christo¤er Kok Sorensen, and Diego Rodriguez-Palenzuela. Macroeconomic propagation under di¤erent regulatory regimes: Evidence from an esti- mated dsge model for the euro area. ECB working papers, 2010.

[26] Morris A. Davis and Jonathan Heathcote. Housing and the business cycle. International Economic Review, 46(3):751�784, 2005.

[27] Antonia Diaz and Maria Jose Luengo Prado. The wealth distribution with durable goods. International Economic Review, 51(1):143�170, 2010.

[28] Douglas R. Fox and Clinton P. McCully. Concepts and methods of the us national income and product accounts. NIPA Handbook, 2009.

[29] Christina Fuentes-Albero. Financial frictions, �nancial immoderation, and the great moderation. working paper, 2009.

[30] Carlos Garriga and Don E. Shlagenhauf. Home equity, foreclosures and bail-outs. work- ing paper, 2009. 42

[31] Andrew Gelman and Kenneth Shirley. Inference from simulations and monitoring con- vergence. working paper, forthcoming in Handbook of Markov Chain Monte Carlo, 2010.

[32] Andrea Gerali, Stefano Neri, Lucca Sessa, and Federico M. Signoretti. Credit and banking in a dsge model of the euro area. working paper, 2010.

[33] Ferre De Graeve. The external �nance premium and the macroeconomy:us post wwii evidence. Journal of Economic Dynamics and Control, 32:3415�3440, 2008.

[34] Stephanie Schmitt Grohe and Martin Uribe. Solving dynamic general equilibrium mod- els using a second order approximation to the policy function. Journal of Economic Dynamics and Control, 28:755�775, 2004.

[35] Fatih Guvenen. A parsimonious macroeconomic model for asset pricing. Econometrica, 77(6):1711�1740, 2009.

[36] Thomas Hintermaier and Winifried Koeniger. Debt portfolios. working paper, 2009.

[37] Matteo Iacoviello. House prices, borrowing constraints, and monetary policy in the business cycle. American Economic Review, 95(3):739�764, June 2005.

[38] Matteo Iacoviello and Stefano Neri. Housing market spillovers:evidence from an esti- mated dsge model. working paper, 2009.

[39] Nir Jaimovich and Max Floetotto. Firm dynamics, markup variations, and the business cycle. working paper, 2008.

[40] Urban Jermann and Vicenzo Quadrini. Financial innovations and macroeconomic volatility. working paper, 2008.

[41] Alejandro Justiniano, Giorgio E. Primiceri, and Andrea Tambalotti. Investment shocks and the relative price of investment. working paper, 2009.

[42] Nobuhiro Kiyotaki and John Moore. Credit cycles. Journal of Political Economy, 105(2):211�248, April 1997.

[43] Paul Klein. Using the generalised schur form to solve a multivariate linear rational expectations models. Journal of Economic Dynamics and Control, 24:1405�1423, 2000.

[44] Keiichiro Kobayashi, Tomoyuki Nakajima, and Masaru Inaba. Collateral constraints and news driven business cycles. working paper, 2007.

[45] Per Krusell and Anthony A. Smith. Income and wealth heterogeneity in the macroecon- omy. The Journal of Political Economy, 83(1):78�97, October 1998.

[46] Zheng Liu, Pengfei Wang, and Tao Zha. Do credit constraints amplify macroeconomic �uctuations? working paper, 2010. 43

[47] Francis A. Longsta¤, Sanjay Mithal, and Eric Neis. Corporate yield spreads: Default risk or liquidity? new evidence from the credit default swap market. Journal of Finance, 6(5):2213�2253, 2005.

[48] Ellen McGrattan and Edward Prescott. Average equity and debt returns: Puzzling? American Economic Review, 93:392�397, 2003.

[49] Atif Mian and Amir Su�. Household leverage and the recession of 2007 to 2009. working paper, 2009.

[50] Jonathan Parker and Annette Vissing-Jorgensen. Who bears aggregate �uctuations and how? American Economic Review, Papers and Proceedings, 2009.

[51] Christopher Pissarides. The unemployment volatility puzzle: Is wage stickiness the answer? working paper, 2008.

[52] Je¤rey S. Rosenthal. Optimal proposal distributions and adaptive mcmc. working paper, forthcoming in MCMC handbook, 2010.

[53] Filippo Scoccianti. Earnings persistence, homeownership pro�le, mobility and increasing mortgage debt. working paper, 2009.

[54] Shouyong Shi. A divisible search model of �at money. Econometrica, 65(1):75�102, 1997.

[55] Frank Smets and Raf Wouters. Shocks and frictions in us business cycles: A bayesian dsge approach. American Economic Review, 97(3):586�606, 2007.

[56] Kamila Sommer, Paul Sullivan, and Randal Verbrugge. Run up in the house-price rent ratio: How much can be explanined by fundamentals? 2009, 2009.

[57] Robert Topel and Sherwin Rosen. Housing investment in the united states. Journal of Political Economy, 96(4):718�740, August 1988.

[58] Stephen D. Williamson and Randall Wright. New monetarist economics: Models. work- ing paper, forthcoming chapter in Handbook of Monetary Economics, 2010.

[59] Adam Zawadowski. The consumption of active investors and asset prices. working paper, 2010.