Credit Risk and the Macroeconomy: Evidence from an Estimated DSGE Model

Embedded in canonical macroeconomic models is the assumption of frictionless financial markets, implying that the composition of borrowers’ balance sheets has no effect on their spending decision. As a result, these models have a difficult time accounting for the feedback effects between financial conditions and the real economy during periods of financial turmoil. Financial frictions—reflecting agency problems in credit markets—provide a theoretical link between the agents’ financial health and the amount of borrowing and hence economic activity in which they are able to engage. This paper attempts to quantify the role of such frictions in business cycle fluctuations by estimating a DSGE model with the financial accelerator mechanism that links balance sheet conditions to the real economy through movements in the external finance premium. Our estimation methodology incorporates a high information-content credit spread—constructed directly from the secondary-market prices of outstanding corporate bonds—into the Bayesian ML estimation. This credit spread serves as a proxy for the unobservable external finance premium, an approach that allows us to estimate simultaneously the key parameters of the financial accelerator mechanism along with the shocks to the financial sector. Our results indicate the presence of an operative financial accelerator in U.S. cyclical fluctuations over the 1973–2008 period: Increases in the external finance premium cause significant and protracted declines in investment and output. The estimated effects of financial shocks and their impact on the macroeconomy also accord well with historical perceptions of the interaction between financial conditions and economic activity during cyclical fluctuations over the past three decades and a half. JEL Classification: E32, E44