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Paying more attention to financial shocks

The financial crisis has made it clear that macroeconomic models need to allocate a more prominent role to financial frictions. This column provides a framework where the financial sector can be the “source” of business cycle fluctuations. The model suggests that credit shocks have played an important role in all major recessions experienced by the US economy during the last two and a half decades.

The ongoing financial crisis has made it clear that macroeconomic models need to allocate a more prominent role to financial shocks and financial frictions. One possible way to achieve this is by adopting a behavioural approach that incorporates elements of “animal spirits”, as outlined, for instance, in the recent book by Akerlof and Shiller (2009). In our own work, we have focused on a different avenue through which financial shocks could affect the macroeconomy – the interaction between nonstandard economic shocks and enforcement problems of financial contracts. We found that these elements have helped our understanding of the current economic downturn as well as of the boom cycle of the 1990s and the 2001 bust.

Financial frictions and the macroeconomy

There is a large body of literature in macroeconomics that formalises financial market frictions in dynamic settings. Bernanke and Gertler (1989) is one of the earliest works that illustrates how financial frictions could have important consequences for macroeconomic fluctuations. Kiyotaki and Moore (1997) provide another possible approach to incorporate financial frictions in a general equilibrium model. These two contributions are now the classic references for most of the work done in this area during the last 15 years.

One motivating observation for considering financial market frictions is that credit is highly pro-cyclical. As shown in the top panel of Figure 1, the change in credit market liabilities moves closely with the cycle. In particular, debt growth drops significantly during recessions. The only exception is perhaps for the household sector in the 2001 recession. However, business sector debt growth declined in 2001. The drop during the recent recession has been especially sizable.

Figure 1.  The business cycle, new debt, and lending standards

Note: Top panel is change in the volume of credit market instruments in the household and business sectors divided by GDP. Data is from teh Flow of Funds of the Federal Reserve Board. Bottom panel is data from the Senior Loan Officer Opinion Survey on Bank Lending Practices from the Federal Reserve Board. Survey was not conducted in 1984 – 1990; we thank Egon Zakrajsek for giving us the historical data for 1967 – 1983.

Of course, the figure does not tell us whether the macroeconomic recession causes the contraction in credit growth or it is the credit contraction that causes the recession. Most of the studies in dynamic macro-finance share the view that the credit contraction exacerbates the recession but does not cause it. Generally speaking, the main view is that something first goes wrong in the nonfinancial sector. This would generate a macroeconomic recession even in absence of frictions in financial markets. With financial frictions, however, the magnitude of the recession is much bigger. Therefore, the main focus of the literature has been on the “amplification” of shocks arising in other sectors of the economy. These could be shocks to productivity, monetary aggregates, interest rates, etc.

The view that financial markets could act as an amplification mechanism is supported not only by the aggregate dynamics of credit flows (as shown in the top panel of Figure 1) but also by indicators of tightening credit standards. The bottom panel of Figure 1 plots the net fraction of senior bank managers reporting tightening credit standards for commercial and industrial loans in a survey conducted by the Federal Reserve Board. Clearly, more and more banks tighten their credit standard during recessions. Other indicators of credit tightening such as credit spreads convey a similar message (see Gilchrist, Yankov and Zakrajsek, 2009).

Although the role played by the financial sector in propagating shocks that arise in other sectors has received considerable attention, few studies have investigated the macroeconomic impact of disturbances that affect the financial sector directly – that is, the role played by the financial sector as the “source” of business cycle fluctuations. We have started to investigate this in recent research (Jermann and Quadrini, 2007, 2009). We have looked at disturbances that directly affect the ability of borrowers and investors to raise funds and studied how these disturbances affect the real sector of the economy. We term these disturbances “financial shocks”.

The recent financial shock

In Jermann and Quadrini (2009), we use financial flows data for the business sector and identify the financial shocks through the lenses of a structural model we developed in Jermann and Quadrini (2006)(2006). The model features both productivity and financial shocks. They are identified using the model’s production function and enforcement constraint, respectively. Feeding the two shocks into the model reveals that credit shocks have played an important role in all major recessions experienced by the US economy during the last two and a half decades. They have been especially important in the most recent recession.

Why does the model lead us to believe that financial shocks have played a central role in the most recent recession? Labour and output dropped sharply starting in the third quarter of 2008, as did the growth in debt, as shown in Figure 1. However, the decline in both multifactor and labour productivity was moderate. The behaviour of productivity clearly excludes the possibility that a negative shock to technology could have been the initial cause of this recession. The fact that the flow of credit declined suggests that something went wrong in the financial sector. Of course, we now all know that something wrong did happen in the financial sector, making our results highly plausible.

What is a financial shock? We think of a financial shock as something changing the ability of borrowers to raise funds. Indirectly, this increases the cost of current operations. In the case of businesses, it increases the “effective” cost of labour, reducing its demand. It is through the reduction in the demand of labour that these shocks can have severe recessionary effects.


The primary goal of our analysis is not to explain or predict problems that arise in the financial sector. What we do is to provide a framework that helps us to understand the macroeconomic consequences of these problems. However, even if we take the financial shocks as exogenous and leave them unexplained, such a framework helps us understand the policies that might reduce the perverse effects of these shocks.

Of course, understanding the causes of a shock is equally important. However, a shock is by definition something the model takes as given and agents cannot predict. Can we interpret these shocks as caused by irrational behaviour or lack of coordination as some prominent scholars suggest? For example, we can interpret the housing market boom that peaked in 2006 and the associated relaxation of credit standards as a consequence of “irrational confidence”. However, this does not have to be the case. In our previous paper (Jermann and Quadrini, 2007), we showed that large asset price increases that fuel large credit expansions can be reconciled with rational expectations when there is uncertainty about the future.

But regardless of whether we interpret these shocks as the outcome of irrational behaviour or just the arrival of truly new information, our goal has been to better understand the consequences of these shocks. Once we understand the consequences, we can start thinking about desirable policies.


Akerlof, G. A. and R. Shiller (2009). Animal Spirits. Princeton University Press, Princeton and Oxford.

Bernanke, B. and M. Gertler (1989). “Agency Costs, Net Worth, and Business Fluctuations”, American Economic Review, 79 (1), 14-31.

Gilchrist, S., V. Yankov, and E. Zakrajsek (2009). “Credit Market Shocks and Economic Fluctuations: Evidence from Corporate Bond and Stock Markets”. Unpublished manuscript, Boston University and Federal Reserve Board.

Kiyotaki, N. and J. H. Moore (1997). “Credit Cycles”. Journal of Political Economy, 105(2), 211-48.

Jermann, U. and V. Quadrini (2006). “Financial Innovations and Macroeconomic Volatility”. NBER Working Paper 12308.

Jermann, U. and V. Quadrini (2007). “Stock market Boom and the Productivity Gains of the 1990s”. Journal of Monetary Economics, 54(2), 413-432.

Jermann, U. and V. Quadrini (2009). “Macroeconomic Effects of Financial Shocks”. CEPR Discussion Paper 7451.

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