The Impact of Securities Regulation on New Keynesian Firms

Abstract

This paper describes a new fact and then analyzes its implication for aggregate fluctuations: sticky-price firms overstated accounting earnings more often than flexible-price firms prior to the passage and implementation of the Sarbanes-Oxley Act (SOX) but refrained more from overstating earnings after SOX. Sticky-price firms also paid lower loan spreads after SOX than before, experienced negative returns around the Enron scandal, and experienced positive returns around the SEC's approval of the change in listing requirements. We develop a New Keynesian model that incorporates both a financial accelerator (Bernanke and Gertler, 1989) and firms featured with differential output-price stickiness. The model mirrors both pre- and post-SOX scenarios and shows that, when investigating the profits reported by sticky-price firms is more costly for lenders, such firms are endogenously more volatile in equity returns and display higher capital-investment and stock-price sensitivities to monetary-policy shocks. Our further empirical analyses yield results that are in line with these model predictions.

Keywords: Nominal Rigidities, New Keynesian Models, Financial Friction, Sarbanes-Oxley Act, Information Disclosure

JEL Classification: D50, E12, E44, G28, G32, G33