Risk and State-Dependent Financial Frictions

A growing literature shows that financial frictions amplify the effects of macroeconomic shocks during times of financial distress. This literature, along with the Great Recession of 2007–2009, has sparked a renewed interest among many central banks for allowing for state-dependent effects of financial frictions in their macroeconomic models.

This paper uses a standard New Keynesian model with financially constrained firms to study the role of state-dependent financial frictions and their implications for how shocks propagate to the macroeconomy. The key insight of the model is that when firms are highly leveraged, they respond more strongly to shocks. This implies that shocks propagate much more strongly in the model when firm leverage and corporate spreads are elevated than when they are low.

Our results show that these nonlinear dynamics are key to account for periods of financial tranquility and distress in the data. We propose a regime-switching model where financial frictions fluctuate between moderate (low risk) and severe (high risk), depending on the state of the economy. We estimate the model on aggregate US data and show that it delivers better model fit than common benchmarks.