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Financial Frictions and Fluctuations in Volatility

Staff Report 466 | Published November 27, 2018

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Cristina Arellano Assistant Director, Policy and Monetary Advisor
Yan Bai University of Rochester, NBER, and CEPR
Patrick J. Kehoe Monetary Advisor
Financial Frictions and Fluctuations in Volatility


The U.S. Great Recession featured a large decline in output and labor, tighter financial conditions, and a large increase in firm growth dispersion. We build a model in which increased volatility at the firm level generates a downturn and worsened credit conditions. The key idea is that hiring inputs is risky because financial frictions limit firms' ability to insure against shocks. An increase in volatility induces firms to reduce their inputs to reduce such risk. Out model can generate most of the decline in output and labor in the Great Recession and the observed increase in firms' interest rate spreads.

Published in: _Journal of Political Economy_ (Vol. 127, No. 5, October 2019, pp. 2049-2103),
[Staff Report 538: Appendix for Financial Frictions and Fluctuations in Volatility](