Business Cycle and Monetary Policy Analysis with Market Rigidities and Financial Frictions
39 Pages Posted: 7 Mar 2013
Date Written: March 5, 2013
We examine business cycle fluctuations in a dynamic macroeconomic model that incorporates a financial accelerator mechanism, borrowing constraints, and frictions on both setting prices and wages. After an adverse financial shock, the slow-adjustment process on wage cuts results in higher production marginal costs, lower firm earnings, and a subsequent reduction in equity that explains the increase in the cost of borrowing and the credit crunch. The real effects of adverse financial shocks are significantly amplified when either considering greater rigidities for price/wage setting or a low elasticity of substitution in loan production (real rigidities in the financial sector). In the monetary policy analysis, a Taylor (1983)-style rule performs slightly better when incorporating a small response coefficient to the spread between borrowing and saving interest rates.
Keywords: financial accelerator, nominal rigidities, real rigidities
JEL Classification: E32, E44
Suggested Citation: Suggested Citation