Ebook Are There Any Spillovers between Household and Firm Financing Frictions? A Dynamic General Equilibrium Analysis
The goal of this paper is to examine possible feedback effects between the strength of credit constraints and external finance premia in the household and in the production sectors of the economy, and the impact of such effects on business cycles. To do this, it proposes a new model of financing frictions for firms and households that explicitly models the external finance spread faced by both types of agents, while improving in several other dimensions on existing models of credit constraints and aggregate fluctuations. Financing frictions are often suggested as a prime candidate for endogenously amplifying and increasing the persistence of even small transitory exogenous shocks. The basic idea, often called the financial accelerator, is that in the presence of credit constraints exogenous shocks can generate a positive feedback effect between the financial health of borrowing firms or households and output (Bernanke, Gertler and Gilchrist (1999) [8]). The standard approach to analysing credit constraints focuses either on households or on firms in isolation. Despite the conjecture that credit constraints can significantly amplify and increase the persistence of small shocks, a frequent finding is that the ability of credit frictions to amplify fluctuations is small or modest and in many circumstances they dampen the effect of shocks on output.
This raises the following question: can allowing for financing frictions both for households and firms simultaneously enhance the ability of financing constraints to amplify shocks and increase the persistence of fluctuations? If both household and firm level financing frictions create financial accelerators which on their own amplify output fluctuations, then intuitively there should be positive a positive interaction between them: if the household level financial constraints increase the sensitivity of output to shocks, then due to the firm level financial accelerator they should amplify the procyclicality of financially constrained firms collateral values and further relax(tighten) their financing constraints in a boom(recession). Similarly, the firm level financial accelerator should increase the procyclicality of households collateral values and increase(decrease) their borrowing ability in a boom (recession). To quote Bernanke et al (1999) [8]:
By enforcing the standard consumption Euler equation (in the firm financial accelerator model), we are effectively assuming that financial market frictions do not impede household behavior... An interesting extension of this model would be to incorporate household borrowing and associated frictions. With some slight modification, the financial accelerator would then also apply to household spending, strengthening the overall effect.
The possibility of such an interaction is particularly relevant in the recession of 2007-2009. Mian and Sufi (2009) [50] rank US counties by the growth rate in household leverage (measured by debt to income) in 2002-2006. They find that in 2006-2008 the unemployment rate increased by about 2.5% more in the top 10% leverage growth counties than in the bottom 10% leverage growth counties. This sort of evidence is suggestive of a positive feedback from the leverage level of households to a decline in aggregate economic activity, which can then affect the tightness of firms borrowing constraint through a financial accelerator effect. The following scenario roughly matches the mechanism underlying many popular and business press reports. A negative aggregate shock reduces the net worth of credit constrained households, raising the cost of borrowing and decreasing spending. The decline in spending lowers the net worth of financially constrained firms, increasing their financing costs and decreasing their demand for labour and capital. This feeds back into further declines in households net worth and spending, again reducing the net worth of credit constrained firms. In a world with perfect competition and no financing frictions this situation would be impossible: for a given level of productivity the lower salaries of workers in the scenario above would stimulate firms labour demand and output. The presence of firm level financing frictions that depend in part on aggregate demand makes this a plausible chain of events even with perfect competition and price flexibility in all markets.
There are several related questions for which understanding the interaction between household and firm credit constraints matters. For example, should we expect a liberalisation in household borrowing conditions to create a general boom including output and investment increases? Can fluctuations in housing prices that affect households borrowing capacity amplify GDP fluctuations? The joint examination of credit constraints affecting households and firms may also matter for analysing policy responses to financial crises. Recent initiatives by many central banks have focused on quantitative easing operations aimed at reducing private sector financing spreads relative to the risk free rate. For example the US Federal Reserve Board launched the Mortgage Backed Securities Purchase Programme in November 2008 with a mandate to purchase up to 1.25 trillion USD of mortgage backed securities during 2009. In parallel, the Fed also launched a commercial paper purchase program with 350 billion USD of purchases by January 2009. This leads to the following question: is it more important to target the spreads on household debt such as mortgages or firm level debt such as commercial paper? The answer may depend significantly on the macroeconomic interaction of the two types of credit constraints.
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