Financial Intermediation, Investment Dynamics, and Business Cycle Fluctuations

Abstract

I use micro data to quantify key features of U.S. firm financing. In particular, I establish that a substantial 35% of firms' investment is funded using financial markets. I then construct a dynamic equilibrium model that matches these features and fit the model to business cycle data using Bayesian methods. In the model, stylized banks enable trades of financial assets, directing funds towards investment opportunities, and charge an intermediation spread to cover their costs. suggests that the answer is 'yes'. I find that financial sector shocks account for 35% and 60% of output and investment volatility, respectively. These are the implications of a dynamic model estimated using the past 20 years of data for the United States.A key input into the analysis is a characterization of how important financial markets are for physical investment. To this end, I analyze the cash flow statements of all the U.S. public nonfinancial companies available in Compustat. I find that 35% of the capital expenditures of these firms is funded using financial markets. Of this funding, around 75% is raised by issuing debt and equity and 25% by liquidating existing assets. My analysis at quarterly frequencies suggests that the financial system is crucial in reconciling imbalances between the positive operating cash flows and capital expenditures.Shocks that affect the degree of efficiency of the financial system in allocating private savings to productive needs can have large effects on capital accumulation and aggregate activity. To quantify the effects of such disturbances on the business cycle, I build a dynamic general equilibrium model with financial frictions in which entrepreneurs, like firms in the Compustat dataset, issue and trade financial claims to fund their investments. The model builds on Kiyotaki and Moore (2008), henceforth KM. In my theoretical framework, trading of financial assets occurs through banks and exogenous shocks can affect the financial intermediation technology. Differently from KM, I assume that prices and wages are sticky and show that this feature of the model is key for the financial shock to generate procyclical movements in labor inputs, consumption and investment.In my model, entrepreneurs are endowed with random heterogeneous technologies to accumulate physical capital. Those entrepreneurs who receive better technologies issue financial claims to increase their investment capacity. Entrepreneurs with worse investment opportunities instead prefer to buy financial claims and lend to more efficient entrepreneurs, expecting higher rates of return than those granted by their own technologies.I introduce stylized financial intermediaries (banks) that bear a cost to transfer resources from entrepreneurs with poor capital accumulation technologies to investors with efficient capital production skills. Banks buy financial claims from investors and sell them to other entrepreneurs. In doing so, perfectly competitive banks charge an intermediation spread to cover their costs (Chari, Christiano, an...

Financial frictions and economy policy

“…private banks borrow from the central bank, they become a decreasing function of the policy rate. 8 1 The analysis of the policy sector follows Walsh (2010, chapter 4) and is also consistent with the analysis in Reis (2017). 8 2 Central banks turn over to the government almost all of the interest earnings on their portfolio of government debt.…”

“…A similar type of collateral constraint can, also, be imposed due to default risk. 8 Under this speci…cation of the collateral constraint, no "overborrowing"could arise. The fact that the borrowing limit is a function of individual and not economy's aggregate variables induce households to internalize the e¤ects that their borrowing decisions have on the collateral value.…”

“…7 The collateral constraint is not derived as an optimal contract between borrowers and lenders, but imposed directly as in the models of Kiyotaki and Moore (1997), Aiyagari and Gertler (1999), Kocherlakota (2000) and Mendoza and Smith (2006) and many others. 8 See e.g. Aguiar and Gopinath (2007).…”

“…Financial frictions can also be introduced via collateral constraints where agents' ability to borrow is constrained to be less than a fraction of the value of its collaterized assets (see e.g. Kiyotaki 7 8 We can add an extra …nancial friction like "bad loans" as in e.g. Corsetti et al (2013), who assume that bad loans are a fraction of total loans, where this fraction increases with the government bond spread.…”

“…Except from the policy shocks de…ned above, all other shocks (namely, TFP and investment shocks) are assumed to follow AR (1) stochastic processes of the form: 1) log A + log A t + " t (162a) 8 5 Following Gertler and Karadi (2011, 2013), we could also allow central banks'purchases of government debt to react positively to the deviation of government bond spread from its steady state value. In our set up, we report that this is not important.…”