Staff Report 466

Financial Frictions and Fluctuations in Volatility

Cristina Arellano | Monetary Advisor
Yan Bai
Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis

Revised December 8, 2016

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 and 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.

RELATED PAPER: Staff Report 538 Appendix for Financial Frictions and Fluctuations in Volatility

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