MACROECONOMIC IMPLICATIONS OF

FINANCIAL CONSTRAINTS

1. Credit crunch.

9th set of transparencies for ToCF

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INTRODUCTION

GREAT DEPRESSION Irving Fisher (EMA 1933): aggrevated by "poor performance" of

financial marketsDEBT DEFLATION

Bernanke (1983): breakdown in banking. Friedman-Schwartz (1963): role of money supply.

BALANCE SHEET CHANNEL vs

LENDING CHANNELTypical pattern:

Recession, high interest rates

weak balance sheets of firms

loan losses + low asset prices reduce equity in financial sector.

Two sectors (real + financial) are constrained.

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US 1990-91 recession (rather typical)

banks: reduction in capital ratio decline in bank lending

Same pattern in the wake of a tight money episode (Romer-Romer BPEA 1990).

Modeling : Apply logic of credit rationing to the two tiers.

flight to quality

– credit crunch hits poor firms first– large/healthy firms can go to CP or bond markets.

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MODEL

Have 1 project / idea each

Moral hazard:

Risk neutral parties borrowers (firms) monitors (banks) investors

("firms")

return R

(success)

Investment costI

Verifiable 0

(failure)

(only good project is viable)

BORROWERS

good bad(low private

benefit)

Versions of the project

Bad (high private

benefit)

Private benefit:Prob( R)

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Have assets Cumulative distribution G(A).

("financial intermediaries", "banks")

can rule out high private benefit bad project of borrower at cost c (moral hazard).

uninformed / free riding (actually: implication of the model),

Exogenous interest rate:access to "storagefacility" yieldinginterest rate i.

Endogenous interest rate:savings.

demand expected return

MONITORS

INVESTORS

Total assets of intermediaries = Km.

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EXOGENOUS INTEREST RATE

Intermediation

Equilibrium

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Certification

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CertificationIntermediation

Venture capitalist Lead investment bank Bankers acceptances(commercial paper)Partial securitization of a loan.

Bank loan(on balance sheet).

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Need

DIRECT FINANCE

where

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INDIRECT FINANCE

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Because firm wants to use as little informed capital as possible:

Firm gets financed if it has assets where

EQUILIBRIUM

is increasing in .

M:

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If interest rate is endogenous

Demand for uninformed capital:

Supply imperfectly elastic.

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COMPARATIVE STATICS3 types of recessions

Lending channel

Classical recession Balance

sheet channel

Correlation. Leads and lags

In the three types of capital squeeze, aggregate investment goes down and goes up.

Credit crunch Industrial recession Shortage of savings[Intermediaries] [Firms]

parameter of first order stochastic dominance

[Investors]

or

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[Empirical evidence.]

Fact: small firms are prime victims of credit crunch.

CREDIT CRUNCH

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VARIABLE INVESTMENT SCALE

solvency ratio of banks (intermediation) increases

equity ratio of firms

A decrease in Km (credit crunch)

decreases increases decreases

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A decrease in Kb (balance sheet channel) decreases

decreases increases rm

decreases rb

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(1)

Description of equilibrium

(2)

(3)

inverse function of

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r increases with c

Intermediation (banks) vs certification (venture capital)

Banks have become low-intensity monitors over the years.

Certifiers have r = 1!

High monitoring intensity high solvency requirements.

Finance companies, firms themselves are higher- intensity monitors better capitalized.

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OTHER RESEARCH PROJECTS

Division of labor between intermediaries and firms, among intermediaries:

shallow vs deep information.

Simultaneous growth of financial and real sectors.Dynamics:

Increasing share of financial sector. Move toward less intensive monitoring.

Certification vs intermediation.