RDP 2011-04: Assessing Some Models of the Impact of Financial Stress upon Business Cycles 1. Introduction

The global financial crisis (GFC) has led to a consideration of how one models the connections between financial stress and the business cycle. These interlinkages currently are the focus of a great deal of research and many models and analyses have emerged that aim to elucidate these relationships, for example Christensen and Dib (2008), Greenlaw et al (2008), Beneš et al (2009), Gilchrist et al (2009), Liu, Wang and Zha (2009) and Gertler and Kiyotaki (2010). These papers deal with a number of issues such as credit availability, collateral and the role of ‘animal spirits’ in initializing and propagating cycles. Questions that naturally arise concern: the size of the financial effects upon cycles in activity, how models can be designed with financial-real linkages and whether such models might be usefully employed to predict recessions. This paper aims to provide a framework to look at such questions and more generally to assess these models.

In Section 2 of the paper we review some of the major contributions to the literature that have addressed extended financial-real linkages over and above those coming from interest rates and monetary factors, which have always been present in conventional models. We outline the various strategies that have been employed, and discuss whether they influence the price or quantity of credit available to agents. We subsequently select two examples of the different strategies which seem to have enjoyed some success – Gilchrist et al (2009) (termed GOZ hereafter) and Iacoviello (2005) – and ask what characteristics of the business or growth cycles are altered by the financial factors in these models. Neither paper directly addresses this issue. Both papers report impulse responses with and without financial factors. In addition GOZ present a decomposition of the level and volatility of the transitory component of GDP into contributions from various identified shocks. One difficulty with the latter is that in this decomposition, output must be fully explained by the model shocks, that is, there is no residual term. Consequently, it is always unclear in such decompositions whether a shock accords with its label or is simply a residual. Our approach is to additionally assess the models on their ability to capture the length, duration and other important characteristics of the business or growth cycles.

For this purpose we assemble some ‘stylised facts’ relating to recessions and the role of credit. These are drawn from a number of sources, but principally from the work of the International Monetary Fund (IMF) reported in the World Economic Outlook, particularly the April 2009 release. Because many of the measures the IMF use emphasise turning points in economic activity, we need a method to locate those. Therefore we adopt the method set out in Harding and Pagan (2002) for locating turning points, which has close connections with the NBER dating of business cycles. We find that, while at least one of the models can replicate some of the features set out in the IMF work, it is clear that neither paper is able to fully capture the effects of financial fragility upon recessions.