The role of financial frictions in the 2007-2008 crisis: an estimated DSGE model

After the banking crises experienced by many countries in the 1990s and in 2008, financial market conditions have turned out to be a relevant factor for economic fluctuations. The purpose of this paper is to determine whether frictions in financial markets are important for business cycles, and whether the recent 2007-2008 crisis has enhanced (or reduced) the size of some shocks and the role played by financial factors in driving economic fluctuations. The analysis is based on both versions of the Smets and Wouters DSGE model (2003, 2007), which are estimated using Bayesian techniques. The two versions differ because the Smets and Wouters (2007) version entails a risk premium shock, which captures that interest rate faced by firms and households might be different from the policy rate because of some unmodelled frictions. Both versions are augmented to include an endogenous financial accelerator mechanism as in Bernanke, Gertler and Gilchrist (1999), which arises from information asymmetries between lenders and borrowers that create inefficiencies in financial markets. The analysis is based on the same data-set as in the Smets and Wouters model, but extended to 2010. One first set of results suggests that the recent crisis has amplified the relevance of financial factors, as well as unmodelled frictions. Overall, this paper proves that the Smets and Wouters model augmented with a financial accelerator mechanism is suitable to capture much of the historical developments in U.S. financial markets that led to the financial crisis in 2007-2008. In particular, the concomitance of a peak in leverage ratio and the deepening of the recession supports the argument that leverage and credit have an important role to play in shaping the business cycle, in particular the intensity of recessions.