Macroeconomics Project
MBA 6410 Project
Part 1
The Financial Accelerator and the Flight to Quality
One puzzle that has long plagued business cycle analysis is the existence of large fluctuations in aggregate economic activity that arise from what seem to be small shocks. This anomaly is what motivated the research into the financial accelerator. The financial accelerator is a possible explanation for these disproportional fluctuations. Changes in the credit market amplify and spread the initial shocks. This is explanation fits particularly well when firms and households are overextended or highly leveraged. This credit-market amplification of economic shocks is the result of reduced access to borrowed funds.
Using the principal-agent approach to credit markets, the financial accelerator builds on the ideas of imperfect information. Studies on the economics of imperfect information have provided three basic points that establish a foundation for the financial accelerator. First, finance from external sources is more expensive than financing internally, unless the external finance is fully backed by collateral. This higher cost of external funds reflects the losses that will be incurred due to the unevenness of information. Second, the cost of external financing has a negative relationship to a borrower’s net worth. Finally, a drop in a borrower’s net worth, increases the cost of borrowing (increases the premium on external finance), increases the amount of external financing required, and reduces the borrower’s production and spending.
From this framework we learn that a dollar outside the firm is worth less than a dollar inside the firm due to the agency cost of lending. Borrowers must compensate lenders for their expected costs of determining credit-worthiness. We also learn that a fall in net worth both increases the agency premium (the cost of borrowing) and decreases the borrower’s spending and production. The gist of the financial accelerator is that fluctuations in
Part 1
The Financial Accelerator and the Flight to Quality
One puzzle that has long plagued business cycle analysis is the existence of large fluctuations in aggregate economic activity that arise from what seem to be small shocks. This anomaly is what motivated the research into the financial accelerator. The financial accelerator is a possible explanation for these disproportional fluctuations. Changes in the credit market amplify and spread the initial shocks. This is explanation fits particularly well when firms and households are overextended or highly leveraged. This credit-market amplification of economic shocks is the result of reduced access to borrowed funds.
Using the principal-agent approach to credit markets, the financial accelerator builds on the ideas of imperfect information. Studies on the economics of imperfect information have provided three basic points that establish a foundation for the financial accelerator. First, finance from external sources is more expensive than financing internally, unless the external finance is fully backed by collateral. This higher cost of external funds reflects the losses that will be incurred due to the unevenness of information. Second, the cost of external financing has a negative relationship to a borrower’s net worth. Finally, a drop in a borrower’s net worth, increases the cost of borrowing (increases the premium on external finance), increases the amount of external financing required, and reduces the borrower’s production and spending.
From this framework we learn that a dollar outside the firm is worth less than a dollar inside the firm due to the agency cost of lending. Borrowers must compensate lenders for their expected costs of determining credit-worthiness. We also learn that a fall in net worth both increases the agency premium (the cost of borrowing) and decreases the borrower’s spending and production. The gist of the financial accelerator is that fluctuations in