The complexity and sophistication of today’s financial instruments and institutions—in a global economy with a high degree of financial integration—were undoubtedly the major factors behind the extraordinarily rapid transmission of financial shocks during the recent crisis. When rising delinquencies on subprime mortgages in the first half of 2007, triggered by the end of the housing boom in the United States, started to lead to large losses on related structured credit products, investors became greatly concerned about structures of securitized financial products more generally and began to pull back from risk-taking. In the late summer of 2007, with investors’ risk appetite diminished substantially, the short-term funding markets in the United States and abroad became severely disrupted, and liquidity in private credit markets dropped sharply.
The initial financial turmoil did not appear to leave much of an imprint on real economic activity. However, the persistent and escalating pressures on bank balance sheets caused a pronounced tightening of aggregate credit conditions, a drop in asset values, and a slump in business and consumer confidence. Indeed, on December 1, 2008, the NBER’s Business Cycle Dating Committee determined that a peak in U.S. economic activity occurred sometime in December 2007. And in spite of a number of unprecedented policy actions by the Federal Reserve and other U.S. government entities to arrest and mitigate the ensuing contraction in economic activity, the 2007–09 downturn has entered the record as the most severe recession, in terms of both its depth and duration, of the postwar period.
The destructive power of this “adverse feedback loop” between financial conditions and the real economy has led to much soul-searching among policymakers and economists. The debate among the former, in particular, has focused on whether central banks should respond only to inflation in the price of goods and economic slack, or if they should also respond to movements in asset prices. The latter group, in contrast, has responded by developing a slew of new dynamic general equilibrium models, in which the deterioration in the equity capital position, or net worth, of financial intermediaries—by reducing the supply of credit—leads to and amplifies the ensuing economic downturn.
Although channels through which disruptions in financial markets can influence economic activity are relatively well understood from a theoretical perspective, assessing their quantitative implications for the real economy remains a considerable challenge. This paper examines the extent to which the workhorse macroeconomic model with financial frictions the New Keynesian model of Christiano et al. [2005] (CEE hereafter) and Smets and Wouters [2007] (SW hereafter) and augmented with the financial accelerator mechanism of Bernanke et al. [1999] (BGG hereafter)—can generate cyclical fluctuations of the type and magnitude experienced by the U.S. economy during the 2007–09 crisis.
