Macroeconomics Project

Topics: Subprime mortgage crisis, Subprime lending, Mortgage Pages: 19 (6751 words) Published: August 4, 2009
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 the net worth of borrowers lead to fluctuations in real activity. In practice, when a firm’s balance sheet or income statement weakens, they drift into violation of financial ratio requirements. Falling asset values reduce a firm’s ability to post collateral. Both of these situations have a direct effect on the firm’s access to credit and the interest rate it must pay.

The financial accelerator builds upon itself. For example, a decline in productivity lowers cash flows and reduces the ability of a firm to finance projects internally. This increases the cost of investment. The fall in investment spending reduces economic activity and cash flows in future periods, and so on. These effects are stronger the deeper an economy is in a recession. The effects of the financial accelerator are also amplified when internal financing is low to begin with. When factors of production are used as collateral for new loans, shocks lower the value of that collateral and further tighten borrowing constraints and reduce spending. This fall in spending further reduces the value of assets, leading to another round of decreased borrowing and spending.

The affects of the financial accelerator also apply to banks. Because banks borrow most of the funds they lend or invest, a drop in bank capital may restrict the size of the bank’s operations by raising its cost of funds through regulatory limits. Households are also impacted by the accelerator. Major purchases, such as housing, are linked to the state of household balance sheets through down payments, income requirements, and up-front transaction costs.

Related to the financial accelerator is the flight to quality. When the agency costs of lending begin to be too high, lenders invest a greater share of their savings in safer alternatives. When the financial accelerator is in effect, credit flows away from borrowers who are more subject to agency costs. This is evidenced by the finding that the share of...
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