Financial Frictions, Investment Dynamics, and the Lost Recovery
AbstractOne of the most puzzling facts in the wake of the Global Financial Crisis is that output across advanced and emerging economy recovered at a much slower rate than anticipated by most economists and forecasting agencies. The research objective of this paper will be to explain the mechanics behind slow recoveries after crises and recessions.
The paper will illustrate a key channel of this phenomenon. Namely, financial frictions in the banking intermediation sector amplify the effect of a shock such as a deterioration of credit quality or a fall in asset prices. Through financial accelerator mechanisms, the shock leads to a severe contraction of investment. In addition, using a DSGE model, we introduce technological improvement embodied in the purchase of new capital, which leads to the possibility of endogenous growth. The collapse in investment impacts the rate of aggregate productivity growth. A temporary banking crisis or negative financial shock that raises the cost of credit or impedes its volume results in a large decline in investment. The fall in the acquisition of technology through investment can potentially lead to a permanent or persistent impact on the level of output if the complementarity between embodied technology and capital is high enough.