Financial Frictions and Fluctuations in Volatility

59 Pages Posted: 3 Jan 2017 Last revised: 27 Oct 2021

See all articles by Cristina Arellano

Cristina Arellano

Federal Reserve Bank of Minneapolis

Yan Bai

University of Rochester - Department of Economics

Patrick Kehoe

Stanford University

Date Written: December 2016

Abstract

During the recent U.S. financial crisis, the large decline in aggregate output and labor was accompanied by both a tightening of financial conditions and a large increase in the dispersion of growth rates across firms. The tightened financial conditions manifested themselves as increases in firms' credit spreads and decreases in both equity payouts and debt purchases. These features motivate us to build a model in which increased volatility of firm level productivity shocks generates a downturn and worsened credit conditions. The key idea in the model is that hiring inputs is risky because financial frictions limit firms' ability to insure against shocks. Hence, an increase in idiosyncratic volatility induces firms to reduce their inputs to reduce such risk. We find that our model can generate most of the decline in output and labor in the Great Recession of 2007–2009 and the observed tightening of financial conditions.

Suggested Citation

Arellano, Cristina and Bai, Yan and Kehoe, Patrick, Financial Frictions and Fluctuations in Volatility (December 2016). NBER Working Paper No. w22990, Available at SSRN: https://ssrn.com/abstract=2892415

Cristina Arellano (Contact Author)

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Yan Bai

University of Rochester - Department of Economics ( email )

Harkness Hall
Rochester, NY 14627
United States

Patrick Kehoe

Stanford University ( email )

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