Working Paper: NBER ID: w22990
Authors: Cristina Arellano; Yan Bai; Patrick J. Kehoe
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.
Keywords: No keywords provided
JEL Codes: E32; E44; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased volatility of firm-level idiosyncratic productivity shocks (D89) | higher risk of default (G33) |
| higher risk of default (G33) | reduced labor hiring (J23) |
| reduced labor hiring (J23) | decreased aggregate output and employment (E23) |
| increased volatility of firm-level idiosyncratic productivity shocks (D89) | reduced labor hiring (J23) |
| increased volatility of firm-level idiosyncratic productivity shocks (D89) | decreased aggregate output and employment (E23) |
| increased volatility of firm-level idiosyncratic productivity shocks (D89) | tighter financial conditions (E44) |