The Implications of Financial Frictions and Imperfect Knowledge in the Estimated DSGE Model of the U.S. Economy

Abstract

In this paper I study how alternative assumptions about expectation formation can modify the implications of financial frictions for the real economy. I incorporate a financial accelerator mechanism into a version of the Smets and Wouters (2007) DSGE model and perform a set of estimation and simulation exercises assuming, on the one hand, complete rationality of expectations and, alternatively, several learning algorithms that differ in terms of the information set used by agents to produce the forecasts. I show that the implications of the financial accelerator for the business cycle may vary depending on the approach to modeling the expectations. The results suggest that the learning scheme based on small forecasting functions is able to amplify the effects of financial frictions relative to the model with Rational Expectations. Specifically, I show that the dynamics of real variables under learning is driven to a significant extent by the time variation of agents' beliefs about financial sector variables. During periods when agents perceive asset prices as being relatively more persistent, financial shocks lead to more pronounced macroeconomic outcomes. The amplification effect rises as financial frictions become more severe. At the same time, a learning specification in which agents use more information to generate predictions produces very different asset price and investment dynamics. In such a framework, learning cannot significantly alter the real effects of financial frictions implied by the Rational Expectations model.

Keywords: DSGE models, financial accelerator, adaptive learning

JEL Classification: E52, E44, E30, C11