Financial Frictions, Monetary Policy and Business Cycles: Developing Quantitative Models of Economic Fluctuations

This project develops quantitative general equilibrium models of business cycles to assess the quantitative role of monetary policy and financial frictions in generating business cycles. The models must be consistent with available microeconomic evidence at the firm and plant level. This project has a sizable empirical component that involves accessing datasets typically not used by macroeconomists. The project develops a new accounting framework for conducting business cycle analysis. This framework and the data suggest the need for new models of business cycle fluctuations. Factors that distort the relationship between the marginal rate of substitution in leisure and consumption and the marginal product of labor, called labor wedges, and factors which distort the relationship between factor inputs and output, called efficiency wedges, play large roles over the business cycle. The challenge is to develop models in which monetary policy and financial frictions introduce labor and efficiency wedges.

The project develops models in which financial frictions induce efficiency wedges. In the data, small firms contract disproportionately following a monetary tightening. A model of endogenous liquidity constraints is developed in which financial frictions affect the use of working capital, particularly for small firms. Larger firms are less affected by liquidity constraints because they have greater access to public debt markets. A monetary tightening disproportionately affects small firms and distorts the use of working capital relative to other inputs by small firms, and thereby produces an efficiency wedge. The project develops models in which small firms discipline the monopoly power of large firms. Financial frictions disproportionately affect small firms. In recessions, financial frictions worsen and small firms' marginal costs rise relative to those of large firms. The economy becomes less competitive and the resulting distortions manifest themselves as labor wedges.

The project is primarily empirical. A proposal to the Census Bureau requesting access to an extensive detailed collection of data at the plant and firm level has been approved. This project analyzes the business cycle characteristics of the size distribution of firms, price-cost margins by firm size, labor productivity by firm size as well as borrowing costs and other measures of financial constraints by firm size. A panel tracking the behaviour of plants and the characteristics of their associated firms will be constructed using data from the Annual Census of Manufactures, the Census of Manufactures and data from publicly available sources.

Broader Impacts: The broader impacts are that the project will help improve the conduct of monetary policy over the business cycle. The projects will also help in the design of regulatory policy aimed at the banking and financial services industry and in the design of policies aimed at new and small firms.