Credit Supply Shocks and Economic Activity in a Financial Accelerator Model

This paper uses the canonical New Keynesian macroeconomic model—augmented with the standard financial accelerator mechanism—to study the extent to which disruptions in financial markets can account for U.S. economic fluctuations during the 1985–2009 period. The key feature of the model is that financial shocks drive a wedge between the required return on capital and the safe rate of return on household savings. A widening of this wedge causes a decline in investment spending and a worsening in the quality of borrowers’ balance sheets, factors that lead to a mutually-reinforcing deterioration in financial conditions. We employ the methodology developed by Gilchrist and Zakraǰsek [2011b] to construct a measure of distress in the financial sector, which is used to simulate the model. Our simulations indicate that an intensification of financial stresses implies a sharp widening of credit spreads, a significant slowdown in economic activity, a decline in short-term interest rates, and a persistent disinflation. Moreover, such financial market disruptions account for the bulk of contraction in U.S. economic activity that occurred during the last three recessions; these disturbances also generate the investment booms that characterized the 1995–2000 and 2003–06 periods. We also consider the potential benefits of a monetary policy rule that allows the short-term nominal rate to respond to changes in financial conditions as measured by movements in credit spreads. We show that such a spreadaugmented policy rule can effectively damp the negative consequences of financial disruptions on real economic activity. JEL Classification: E30, E44, E52