Optimal Bayesian Estimation of Financial Frictions: An Encompassing View

This paper compares the environments in Bernanke et al. (1999) and Gertler and Karadi (2011), two popular frameworks used to incorporate financial frictions in macroeconomic modelling. We show that the key practical difference between the two frameworks lies in their implications for the link between leverage and expected future spreads of capital returns over safe rates: while the former pairs leverage to one-period-hence such spreads, the latter connects it to a distributed lag of all future spreads. We argue that this difference between the two frameworks is more crucial than the distinction often discussed in the literature, which is related to the specific location of the friction on the borrower-intermediary-entrepreneur financing chain. The paper then compares quantitative versions of the frameworks, estimated using Bayesian procedures and decoupling parameter settings related to steady states from those involving the economy’s dynamic solution around that steady state. We find that when this flexible approach in used, the friction proposed by Gertler and Karadi (2011), which emphasize long-term forward-looking behavior in the leverage equation, is preferred by aggregate data.