Financial Frictions in Macroeconomic Fluctuations

Vincenzo Quadrini
(presented by Chi-Wa Yuen)

June 10, 2013

Introduction
Role of nancial frictions in business cycles (and crises) as
impulse source of uctuations?
propagation mechanism amplication of shocks?

Financial cycles empirical regularity about nancial variables (both prices and
quantities) and their relations with other macro variables over the business cycle?

Salient features of models with nancial-market frictions

missing/incomplete markets departures from Arrow-Debreu and ModiglianiMiller worlds due to
asymmetric information;

limited enforcement;
heterogeneity in preferences/endowments/technologies between two groups of
agents that would end up being suppliers and demanders of loanable funds in
terms of preferences.

Baseline model w/o nancial frictions

2 periods: t = 0; 1:
2 agents: worker (w) vs. entrepreneur (e) ; diering in
e and w > e (?) ;
preferences: "w
>
0
=
"
h
h

endowments: worker owns B vs. entrepreneur owns K ;

technologies
y0w

= 0 vs.

y0e

= A0K

w
y1w = A1G k0;1
A1 > 1 ;
j

1
e
h0

e ; with G0 (k )
vs. y1e = A1k0;1

k0;1 = j i0 + (1
) k 1;0; j = w; e; with
kw1;0 = 0 < K = ke 1;0; and = 0:

= 0;

1 for k 1 0 and

( );

Complete, perfectly competitive markets for labor(t = 0) ; capital (t = 1) ; bonds

(t = 0) ; and goods (t = 0; 1) :

2.1

The worker
Workers problem
max

n
w w w w
hw
0 ;c0 ;c1 ;k0;1 ;b0;1

20
6B

w
o E0 4@c0

1
2
hw
0
C
A+

cw
15

8
w + q k w + p bw
w + B;
>
c
w
h
>
0
0
0
0
0;1
0;1
0
<
w + bw ;
s:t: cw
A
G
k
1
1
0;1
0;1
>
>
: cw
cmin ' 0; t = 0; 1;
t

given fw0; p0; q0; B; A1; g :

Utility-maximizing conditions
w
0

wq
0 0

w
0

=1= w
1

w;
1

(F OC (cw
t ))

ww ;
hw
=
0
0 0

(F OC hw
0 )

w A G0 k w ;
1 1
0;1

w )
(F OC k0;1

wp
0 0
w ( cw
t
t

w;
1

cmin) = 0; t = 0; 1:

(F OC bw
0;1 )
(CSC (cw
t ))

cw
1 > cmin

Assume A1 > 1; then

above conditions can be simplied to

CSC (cw
1)

=)

w
1

w
hw
0 = (1 + 0 ) w0 ;
0
w
(1 + w
0 ) q0 = A1 G k0;1 ;

(1 + w
0 ) p0 = ;
w (cw
0
0

cmin) = 0:

= 0

F OC (cw
1)

=)

w
1

= 1: The

(F OC hw
0 )
w )
(F OC k0;1

(F OC bw
0;1 )
(CSC cw
0 )

2.2

The entrepreneur
Entrepreneurs problem
e
max
n
o E0 (c0 +
e ;be
he0 ;ce0 ;ce1 ;k0;1
0;1

ce1)

8 e
e + p be
c0 + q0k0;1
N0 + ei N;
>
0
>
0;1
>
>
>
1
>
e
e
e
>
N
+
q
K
B;
where
A
K
h
>
0
0
0 h
>
0
0
0
>
< e
e
1)
;
where
i
arg
max
q
E
(
q
i
(
)
i
0
0
s:t:
0
0
0
i
>
e
e
e
>
>
c1 A1k0;1 + b0;1;
>
>
>
e
>
>
c
cmin ' 0; t = 0; 1;
>
>
: et
i0 0;

given fw0; p0; q0; B; K; A0; A1; ; ;

( )g :

w0he0;
ie0

Utility-maximizing conditions
e
0

e
0

= 1 = e1

w0 = (1
e [q E (
0 0

ep
0 0

(F OC (cet))

(F OC he0 )

1] + ei = 0;

eq
0 0

e ( ce
t t

K
he0

) A0

e;
1

eA ;
1 1

e )
(F OC k0;1

e;
1

(F OC be0;1 )

cmin) = 0; t = 0; 1;
e ie
i 0

(F OC ie0 )

= 0:

(CSC (cet))
(CSC ie0 )

Assume
simplify

A1 > 1; then ce1 > cmin

e ; be
F OC ie0; k0;1
0;1 to

CSC (ce1 )

=)

e
1

=0

F OC (ce1 )

q0E ( ) 5 1; (= if ie0 > 0)

=)

e
1

= 1: We can

(F OC ie0 )

(1 + e0) q0 = A1;

e )
(F OC k0;1

(1 + e0) p0 = :

(F OC be0;1 )

2.3

Combining workers and entrepreneurs F OCs

hw
0

= w0 = (1
w
1+ 0

) A0

K
he0

w
A1G0 k0;1
A1
= q0 =
e;
1+ w
1
+
0
0

1+

w
0

= p0 =

1+

(F OC (h0))

(F OC k0;1 )
e;
0

(F OC b0;1 )

e
F OC b0;1 =) w
0 = 0 = 0:
w
w = 0:
Given -symmetry, F OC k0;1 =) G0 k0;1
= 1 =) k0;1

The asset prices are thus given by p0 = 1+

and q0 = 1+A1 ; so that pq0 = A1:

0
0

e
In equilibrium, hw
0 = h0 = h0 : F OC (h0 ) then implies

h0 = (1
2

w0 = 4(1

) A0K (1 + 0)

) A0

K
1+ 0

1
1+

1
! 3 1+

2.4

Market clearing
Labor: hs0
Capital: k1s

e
hw
=
h
0
0

hd0

w + ke
ie0 + K = k0;1
0;1

k1d (assuming zero rate of depreciation)

e
Bonds: bw
0;1 + b0;1 = 0;

Final/intermediate goods
he0

y0d

e
e
cw
0 + c0 + i0 = A0 K

y1d

e = A G kw + A ke
cw
+
c
1 0;1
1
1
1
0;1

y0s;
y1s:

2.5

Business cycle implications

2.5.1

Case (i) : Reproducible capital [E ( ) = 1]

The assumption A1 > 1 implies the following

ie0 > 0
A1 1;

cw
0

F OC (ie0 )

=0=

=)
ce0

q0 = 1 (given

=) 0

F OC (b0;1 )

e ;be
F OC k0;1
0;1

e
i

= 0)

A1

=)

p0 = A1 or r0;1 =
1

1 > 0:

Given 1 + 0 = A1; we have

h

h0 = (1

w0 = (1

) A0K ( A1)

) A0

K
A1

1
1+

1
1+

@ ln(h )

@ ln(h )

1 =
0 ;
=) @ ln(A0 ) = 1+
@ ln(A1 )
0
@ ln(w )

@ ln(w )

1 &
0 =
=) @ ln(A0 ) = 1+
@ ln(A1 )
0

1+

@ ln(w h )

@ ln(w )

2 &
0 = 1
@ ln(A0 )0 = 1+
1+ :
@ ln(A1 )
0

Macro eects of a change in current productivity (4A0) and expected future

productivity (4A1)
y0 = A0K h10

@ ln(y )

@ ln(y )

2 &
0 = 1
=) @ ln(A0 ) = 1+
1+ ;
@ ln(A1 )
0

i0 = y0 (given c0 = 0);
w = 0; given F OC k w ; k e
k0;1
0;1 0;1 ;
@ ln(k )

2
e = i + K = k =)
1 =
k0;1
0
1
1+
@ ln(A0 )
@ ln(y )

2
y1 = A1 (1 + k1) =) @ ln(A1 ) = 1+
0

c 1 = y1 ;
q0 = 1;

i0
k1
i0
1+k1

@ ln(k )

& @ ln(A1 ) = 11+

1
@ ln(y )
& @ ln(A1 ) = 1+ 11+
1

i0
k1

i0
1+k1

 p0 = 1=A1;
w0 h0 +B
bw
=
=
0;1
p0

be0;1 > 0; i.e., entrepreneur borrows from worker.

=)h "

e
Increase in A0 =)0 y0 "=) i0 " (given c0 = 0) =) k1 = k0;1
"=) y1 " :
e
Increase in A1 =) h0 "=) y0 "=) i0 " (given c0 = 0) =) k1 = k0;1
"=)
y1 " :

2.5.2

Case (ii) : Fixed capital [E ( ) = 0]

F OC ie0 =) ie0 = 0
e = K; given k w = 0;
k0;1
0;1

cw
0

+ ce0

= y0 > 0

CSC(c0 )

=)

= 0;

F OC k0;1 =) q0 = A1 > 1 =) both agents are indierent between

e becomes indeterminate.
current and future consumption, so that bw
=
b
0;1
0;1
Given 0 = 0; we have
h

h0 = (1
h; w:

) A0K

1
1+

@ ln(x )

@ ln(x )

1 &
0 = 0; x =
= w0 =) @ ln(A0 ) = 1+
@ ln(A1 )
0

Macro eects of a change in current productivity (4A0) and expected future

productivity (4A1)

 y0 = A0K h10

@ ln(y )

@ ln(y )

2 &
0 = 0;
=) @ ln(A0 ) = 1+
@ ln(A1 )
0

c0 = y0 (given i0 = 0);
w = 0; given F OC k w ; k e
k0;1
0;1 0;1 ;
@ ln(k )

@ ln(k )

e = K = k =)
1 = 0 =
1 ;
k0;1
1
@ ln(A0 )
@ ln(A1 )
@ ln(y )

@ ln(y )

y1 = A1 (1 + k1) =) @ ln(A1 ) = 0 & @ ln(A1 ) = 1;

0
1
q0 = A1 > 1;
p0 = :
=)h "

Increase in A0 =)0 y0 "=) c0 " (given i0 = 0) =) no eects on k1 and y1:

Increase in A1 =) y1 " (given k1 = K ), but no eects on h0; y0; c0; and
i0 (= 0) :

Friction #1: Costly state verication (under asymmetric information) la Bernanke-Gertler

Assume frictions in the production of new capital goods. The productivity parameter is freely observable by the entrepreneur, but can only be observed by other
agents by incurring a verication cost per unit investment ie0:
( ) is common
knowledge, though.

Suppose E ( ) = 1: This guarantees capital accumulation in equilibrium.

The entrepreneur nances her investment ie0 partly by using her internal funds N0
(net worth before the production of new capital goods) and partly by borrowing
k (denominated in new capital).
external funds ie0 N0 at the interest rate r0;1

k
Default if ie0 < 1 + r0;1

<

ie0

k
1 + r0;1

N0 or if
ie0

N0
ie0

k ):
= ( N0 ; ie0 ; r0;1
( ) (+) (+)

In case of default, the lender would pay the cost ie0 to observe the true value of
and then conscates the entrepreneurs residual assets (
) ie0:
Zero-prot condition for (intra-period loan made by) the lender:
n

q0 E < [(

) ie0] + E

k
1 + r0;1

e
k = rk
which denes implicitly r0;1
0;1 N0 ; i0 ; q0 :

(ie0

N0 )

io

= ie0

N0 ;

The entrepreneurs utility-maximization problem is the same as the one stated in the
baseline model except that her net worth after the production of new capital as

represented by the RHS of the period-0 budget constraint, viz., N0 + ei should

now be written as

N = N (N0 ; q 0 ; )
i0 = i0 (N0; q0)

max 0; q0
arg max E

i0
n

ie0

k (N ; i ; q )
1 + r0;1
0 0 0

(i0

k (N ; i ; q )
1 + r0;1
0 0 0

N0 )
(ie0

oo

; where
o

N0 ) :

3.1

Business cycle implications

N0 (internal nance only) vs. i0 > N0 (external

Two possible equilibria: i0

nance is necessary).

Focus on the latter case, esp. when N0 < i0 (N0; q0) < A0K h10
c0 > 0 and 0 = 0:

; so that

In this case, q0 = A1 > 1:

Labor employment h0 =
@ ln(x0 )
@ ln(A1 )

= 0; x = h; w:

Output y0 = A0K h10

(1

) A0K

@ ln(y )

1
1+

@ ln(x )

1
= w0 =) @ ln(A0 ) = 1+
0

@ ln(y )

2 &
0 = 0:
=) @ ln(A0 ) = 1+
@
ln(A
0
1)

&

3.1.1

Increase in A0

=)h "
A0 " =)0 y0 "=) e0 "=) N0 "=) i0 "=) k1 "=) y1 " :
e+q K
For eects to be bigger than in baseline model, we require N0
0
0
y0 "; which in turn requires B > q0K unlikely to hold empirically.

B ">

In other words, this kind of nancial friction would likely dampen the impact of a
transitory productivity shock.

3.1.2

Increase in A1

A1 "=) y1 " & q0 "=) N0 " =) i0 "=) k1 "=) y1 " :

k "=)
But q0 "=) r0;1
"; i.e., the cost of external nancing as well as the
probability of default would increase in response to an anticipated productivity (or
news) shock, thus implying pro-cyclicality of interest-rate premia and bankruptcy
rates (which can be reverted by adding adjustment cost of investment).

3.1.3

Quantitative performance

Financial accelerator models like this fail to amplify signicantly eects of productivity shocks, but can do so for other types (e.g., monetary-policy) of shocks.

The model could generate greater persistence, though, because k1 "=) N1 "
i1 "=) k2 "=) y2 " & N2 "
:::

k #
=)r1;2

=)

i2 "=) k3 "=) y3 " & N3 "

k #
=)r0;1

=)

k #
=)r2;3

=)

Friction #2:

Collateral constraint (under limited

enforcement) la Kiyotaki-Moore
Assume frictions in the enforcement of loan contracts, given borrowerss ability to
repudiate debt.
The following collateral constraint has to be added to the entrepreneurs utilitymaximization problem
be0;1

e :
q1k0;1

('0)

Suppose E ( ) = 0; so the entrepreneur has no incentive to invest and the RHS of

her period-0 budget constraint simplies to N0:
e ; be
F OC he0; ce0; ce1 same as before, but F OC k0;1
0;1 have to be revised

(1 + e0) q0 = A1 + '0 q1;

e )
(F OC k0;1

(1 + e0) p0 =

(F OC be0;1 )

+ '0 :

w ;
Combining F OC k0;1 with F OC b0;1 and noting that q1 = A1G0 k0;1
w =K
e ; we get
where k0;1
k0;1

'0 =

(1

G0 K

) G0 K

e
k0;1
e
k0;1

( )

4.1

Business cycle implications

Focus on the case where collateral constraint is binding
( )

'0 > 0 =) G0 K

e
k0;1
<1

e < K; so that k w > 0:

=) k0;1
0;1

In this case, ce0 = 0 and e0 > 0:

But cw
0 = y0

ce0 > 0; so that w

0 =0

w
F OC k0;1

=)

q0 = A1G0 K

e
k0;1
:

e and ce = 0; entrepreneurs period-0 budget constraint implies

When be0;1 = q1k0;1
0

(q 0

e =N
p0q1) k0;1
0

e
0

+ q0 K

B;

where the term q0

p0q1 can be interpreted as the minimum down-payment
required to purchase each unit of new capital.

Since q1 = A1G0 K
tion as

e
k0;1
e =
k0;1

w ;bw
F OC k0;1
0;1

1
1

q0
p0 ;

we can rewrite the above condie

0

B
q0

4.1.1

Increase in A0
A0 "=) y0e (= y0) "=)

Direct eects:
(> y1w #) and y1 "

( ) e
e "=
) k0;1 "
0

w #) =) y e "
(but k0;1
1

e "=) q " = A G0 K
Indirect (amplication) eects: A0 "=) ::: =) k0;1
0
1
e " if B > e (i.e., if the entrepreneur is highly leveraged).
k0;1
0

e
k0;1

4.1.2

Increase in A1
e
e "
+ A1k0;1
k0;1

Direct eects: A1 "=) y1 = A1G K

Indirect (amplication) eects:

(

A1 "=) q0 " =
(

A1G0 K

e
k0;1

"=)

e "=) q " =) k e "=) q " =) k e "=) ::: =) y " :

k0;1
0
0
1
0;1
0;1

In other words, anticipated news could generate asset-price boom, but still no
impact eects on current output.

4.1.3

Quantitative performance

Amplication eects are weak.

Reasons
direct eects of frictions are on investment, with marginal eects on capital and
labor (the factor inputs that produce output); V working capital model
low volatility of asset prices, which determine the stringency of the (endogenous)
borrowing constraint.
risk aversion(?)