Financial Constraints, Financial Shocks, and Business Cycle Accounting

Abstract

This thesis features three closely related chapters investigating the role of the investment wedge in affecting macroeconomic fluctuations. The first chapter shows that the Business Cycle Accounting (BCA) methodology is sensitive to the specification of households preferences in identifying the role of the investment wedge. A poor performance of the investment wedge and of the financial frictions it represents, such as the one BCA finds on 2007-2010 US data and other past events, is compatible with a simulated recession fully driven by financial factors and financial accelerator mechanisms when preferences are not correctly specified in the BCA tool. The second chapter investigates the conditions under which a shock to the risk premium paid by entrepreneurs on bank funds, i.e. a shock to the investment wedge, is able to generate a pro-cyclical response of aggregate consumption. The analysis shows that a minimum degree of nominal stickiness a-la-Calvo and non-separable households preferences of the GHH type, are sufficient conditions for solving the problem of counter cyclicality of consumption in the presence of financial shocks. The third chapter is an application of the BCA tool-kit to the Swedish boom-bust cycle of the late 1980s. The efficiency wedge plays an essential role in explaining the cycle while the investment wedge plays a minor role, adding to the persistence of the recession. Calibrating a BGG model to Sweden according to the findings of the BCA shows that financial deregulation reforms in Sweden did not affect the vulnerability of the economy to the recessionary shock.