Financial Differences and Business Cycle Co-Movements in a Currency Area

I propose a unitary framework to interpret the links between differences in financial structures and the monetary policy regimes, on the one hand, and the correlation of business cycles, on the other. Using a two-country micro-founded model with financial frictions I predict that a greater financial diversity should reduce cyclical correlation under a given monetary regime and that moving from independent monetary policies to a hard peg or a common currency should increase it, for any given degree of financial diversity. I use the recent experience of EMU to test these ideas and show that my model explains reasonably well the broad patterns of business cycle correlation observed recently among the main euro area countries.     

Finance and international business cycles

Business cycles are more correlated among countries that have similar financial structures. We first document this empirical regularity using OECD data, and then build a two-country DSGE model with financial frictions that replicates it. Alternative monetary policy regimes and parameter values are explored. Output co-movements increase when the countries involved are linked by a credible exchange rate peg and when they open up to trade; they decrease when their financial openness increases. The model also accounts for a number of stylized facts of international business cycles, such as the positive international correlation of output, investment and employment.     

Welfare Cost of Fluctuations When Labor Market Search Interacts with Financial Frictions

We study the welfare costs of business cycles in a search and matching model with financial frictions. The model replicates the volatility on labor and financial markets. Business cycle costs are sizable. Indeed, the interactions between labor market and financial frictions magnify the impact of shocks via (i) a credit multiplier effect and (ii) an endogenous wage rigidity inherent to financial frictions. In addition, in a nonlinear framework, large welfare costs of fluctuations are explained by the high average unemployment and the low job finding rates with respect to their deterministic steady‐state values.     

Optimal Monetary Policy Rules and House Prices: The Role of Financial Frictions

We probe the scope for reacting to house prices in simple and implementable monetary policy rules, using a New Keynesian model with a housing sector and financial frictions on the household side. We show that the social‐welfare‐maximizing monetary policy rule features a reaction to house price variations, when the latter are generated by housing demand or financial shocks. The sign and size of the reaction crucially depend on the degree of financial frictions in the economy. When the share of constrained agents is relatively small, the optimal reaction is negative, implying that the central bank must move the policy rate in the opposite direction with respect to house prices. However, when the economy is characterized by a sufficiently high average loan‐to‐value ratio, then it becomes optimal to counter house price increases by raising the policy rate.     

International business cycles with domestic and foreign lenders

We examine the international transmission of business cycles in a two-country model where credit contracts are imperfectly enforceable. In our economy, foreign lenders differ from domestic lenders in their ability to recover value from borrowers’ assets and, therefore, to protect themselves against contractual non-enforceability. The relative importance of domestic and foreign credit frictions changes over the cycle. This induces entrepreneurs to adjust their debt exposure and allocation of collateral between domestic and foreign lenders in response to exogenous productivity shocks. We show that such a model can explain the comovement of output across countries.     

Financial Development,Credit, and Business Cycles

How does financial development affect the magnitude of the business cycles fluctuations? We examine this question in a general equilibrium model with heterogeneous agents and endogenous credit constraints based on Kiyotaki (1998). We show that there is a hump‐shaped relationship between the degree of financial frictions and the amplification of unexpected productivity shocks. This nonmonotonic relation is due to the fall in financial frictions having two opposite effects on the response of output. One effect is the reallocation of productive inputs between agent types, which, while active, increases with the fall in financial frictions. The other effect is the change in the demand of inputs, which decreases with the fall in financial frictions. At low levels of financial development, the reallocation effect dominates and a fall in financial frictions increases the amplification of productivity shocks. In contrast, at higher levels of financial development, a fall in financial frictions decreases the shock amplification because the reallocation effect disappears while the effect on the demand of inputs is still present.     

Emerging Market Business Cycles: The Role of Labor Market Frictions

Emerging economies are characterized by higher variability of consumption and real wages relative to output and a strongly countercyclical current account. A small open economy model with search‐matching frictions and countercyclical interest rate shocks can account for these regularities. Search‐matching frictions affect permanent income, and increase future employment uncertainty, heightening workers' incentives to save and generating a greater response of consumption and the current account. The greater consumption response feeds into larger fluctuations in workers' willingness to work, while interest rate shocks lead to variations in firms' willingness to hire; both of these outcomes contribute to highly variable wages.     

Multinational banking and the international transmission of financial shocks: Evidence from foreign bank subsidiaries

Using bank-level data on 368 foreign subsidiaries of 68 multinational banks in 47 emerging economies during 1994–2008, we present consistent evidence that internal capital markets in multinational banking contribute to the transmission of financial shocks from parent banks to foreign subsidiaries. We find that internal capital markets transmit favorable and adverse shocks by affecting subsidiaries’ reliance on their own internal funds for lending. We also find that the transmission of financial shocks varies across types of shocks; is strongest among subsidiaries in Central and Eastern Europe, followed by Asia and Latin America; is global rather than regional; and becomes more conspicuous in recent years. We also explore various conditions under which the international transmission of financial shocks via internal capital markets in multinational banking is stronger, including the subsidiaries’ reliance on funds from their parent bank, the subsidiaries’ entry mode, and the capital account openness and banking market structure in host countries.     

Credit crunch in a small open economy

We construct an open-economy DSGE model with a banking sector to analyze the impact of the recent credit crunch on a small open economy. In our model the banking sector operates under monopolistic competition, collects deposits and grants collateralized loans. Collateral effects amplify monetary policy actions, interest rate stickiness dampens the transmission of interest rates, and financial shocks generate non-negligible real and nominal effects. As an application we estimate the model for Poland-a typical small open economy. According to the results, financial shocks had a substantial, though not overwhelming, impact on the Polish economy during the 2008/09 crisis, lowering GDP by approximately 1.5 percent.     

Joint effect of financial fragility and macroeconomic shocks on bank loan losses: Evidence from Europe

A reduced-form model including nonlinearities is estimated from pooled data from nine European countries during 1982–2004 to show the effects of macroeconomic shocks and financial fragility on bank loan losses. The main ingredients of the model are unanticipated-output and interest-rate shocks estimated from published macroeconomic and naïve forecasts. The model fits the data well, capturing the extremely high levels of loan losses witnessed in different financial crises.     

Credit and Banking in a DSGE Model of the Euro Area

This paper studies the role of credit supply factors in business cycle fluctuations using a dynamic stochastic general equilibrium (DSGE) model with financial frictions enriched with an imperfectly competitive banking sector. Banks issue collateralized loans to both households and firms, obtain funding via deposits, and accumulate capital out of retained earnings. Loan margins depend on the banks' capital‐to‐assets ratio and on the degree of interest rate stickiness. Balance‐sheet constraints establish a link between the business cycle, which affects bank profits and thus capital, and the supply and cost of loans. The model is estimated with Bayesian techniques using data for the euro area. The analysis delivers the following results. First, the banking sector and, in particular, sticky rates attenuate the effects of monetary policy shocks, while financial intermediation increases the propagation of supply shocks. Second, shocks originating in the banking sector explain the largest share of the contraction of economic activity in 2008, while macroeconomic shocks played a limited role. Third, an unexpected destruction of bank capital may have substantial effects on the economy.     

Tax Evasion,Investment Shocks,and the Consumption Puzzle: A DSGE Analysis with Financial Frictions

Recent studies identify Marginal Efficiency of Investment (MEI) shocks as important drivers of the business cycle. However, Dynamic Stochastic General Equilibrium (DSGE) models struggle to explain macroeconomic comovements between consumption and the key real variables after a MEI shock. Moreover, engaging in tax evasion practices is often an answer to financial constraints, which have been recognized as important determinants of cyclical fluctuations as well. We use a medium-scale New Keynesian DSGE model, that combines tax evasion with financial frictions, to simulate a MEI shock. We show that entrepreneurial tax evasion can solve the comovement problem to a fair extent.     

External Constraints on Monetary Policy and the Financial Accelerator

We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. Our goal is to explore the connection between the exchange rate regime and financial distress. We first show that a calibrated version of the model captures well the behavior of the Korean economy during its financial crisis period of 1997–98. In particular, the model accounts for the sharp increase in lending rates and the large drop in output, employment, investment, and measured productivity. The financial market frictions play an important role, further, explaining roughly half the decline in overall economic activity. We then perform some counterfactual exercises to illustrate how the fixed exchange rate regime likely exacerbated the crisis by tying the hands of monetary policy.     

Financial shocks and the US business cycle

Employing the financial accelerator (FA) model of Bernanke et al. [1999. The Financial accelerator in a quantitative business cycle framework. In: Taylor, J.B., Woodford, M. (Eds.), Handbook of Macroeconomics, vol. 1C. Handbooks in Economics, vol. 15. Elsevier, Amsterdam, pp. 1341-1393] enhanced to include a shock to the FA mechanism, we construct and study shocks to the efficiency of the financial sector during post-war US business cycles. These shocks are found to (i) be very tightly linked with the onset of recessions, more so than TFP or monetary shocks; (ii) remain contractionary after recessions have ended; (iii) account for a large part of the variance of GDP; (iv) be generally much more important than money shocks and (v) be strongly negatively correlated with the external finance premium.     

Equilibrium Indeterminacy and Asset Price Fluctuation in Japan: A Bayesian Investigation

This paper investigates sources of asset price fluctuation in Japan using an estimated financial accelerator model. For explicit treatment of expectational beliefs characterized by sunspots, the model is analyzed over the parameter space where the equilibrium can be indeterminate. We show that indeterminacy arises if the financial accelerator effect is sufficiently large. According to our Bayesian estimation results, Japan's economy was affected by sunspot shocks; however, the contribution of the sunspots to asset price volatility was low. Rather, net worth and cost shocks drove the asset price fluctuation. We find, however, that the sunspots substantially affected capital investment.     

Market timing,investment, and risk management

The 2008 financial crisis exemplifies significant uncertainties in corporate financing conditions. We develop a unified dynamic q-theoretic framework where firms have both a precautionary-savings motive and a market-timing motive for external financing and payout decisions, induced by stochastic financing conditions. The model predicts (1) cuts in investment and payouts in bad times and equity issues in good times even without immediate financing needs; (2) a positive correlation between equity issuance and stock repurchase waves. We show quantitatively that real effects of financing shocks may be substantially smoothed out as a result of firms' adjustments in anticipation of future financial crises.     

Foreign Direct Investment and Debt Financing in Emerging Economies

The rich dynamics of capital flows is an important characteristic of business cycles in emerging market economies. In the data external debt is always procyclical, while FDI is procyclical only in normal times. We provide a microfounded rationale for this pattern by linking financial shocks to capital flows. For this purpose, we build a small open economy model in which firms are subject to borrowing constraints, and are either owned domestically or by foreign investors who purchase firms through FDI. During a financial crisis, the valuation gap per unit net worth between foreign and domestic investors widens, which triggers more FDI inflow. Our model produces business cycle moments consistent with empirical observations.     

Financial Frictions,Investment Delay,and Asset Market Interventions

We construct a dynamic macro model to incorporate financial frictions and investment delay. Investment is undertaken by entrepreneurs who face liquidity frictions in the equity market and a collateral constraint in the debt market. After calibrating the model to the U.S. data, we quantitatively examine how aggregate activity is affected by a shock to equity liquidity and a shock to entrepreneurs' borrowing capacity. We then analyze the effectiveness of government interventions in the asset market after such financial shocks. In particular, we compare the effects of government purchases of private equity and of private debt in the open market. In addition, we examine how these effects of government interventions depend on the option to delay investment.     

Granular institutional investors and global market interdependence

We study the propagation of global investment risk across markets through the granular view of institutional investors. Applying the conditional value-at-risk estimation to micro-level weekly observations of international mutual funds between 2003 and 2011, we find that idiosyncratic shocks to large institutional investors explain both aggregate market risk and cross-market risk interdependence. Conditional on the US capital markets being in financial distress, idiosyncratic shocks to the top 10% largest funds investing in the US explain about 40% of the risk fluctuations in other non-US markets. The findings are also economically and statistically significant for the top largest funds investing in non-US markets, with the effects becoming especially large during the global financial crisis of 2007–09. These results are robust after controlling for common risk factors and applying alternative measures of idiosyncratic shocks.