Financial Frictions and Business Cycles

Abstract

This thesis investigates the business cycle implications of financial frictions for small open economies. Dynamic, stochastic, general equilibrium frameworks with financial and informational frictions and uncertainty in production processes are developed in order to analyze aggregate fluctuations and propagation mechanisms in the case of technology, money growth and risk premium shocks. Informational asymmetries among the agents and Holmstrom-Tirole type of uncertainty in the production processes necessitate financial intermediation and collateralized borrowing in the model economies, where the capital stock of the firms serves as the collateral as well as the factor of production. Financial frictions are in the form of restrictions on the composition of deposits held by the financial intermediaries in the economy. In the first chapter of the thesis, a real, small open economy framework is constructed to explore the implications of increasing financial openness for the impact of temporary technology shocks on the economy. The simulation experiments with different levels of financial openness reveal that increasing financial openness amplifies the impact of positive, temporary technology shocks on output, investment, consumption, labor supply and net exports. The second chapter of the thesis extends the model in the first chapter in such a way that money is incorporated into the economy. Through introduction of a central bank that is responsible for the monetary injection into the economy, the framework is enriched such that money growth shocks as well as technology shocks can be examined under increasing financial integration. One major novelty of this chapter is that it combines two strands of literature: the cash-in-advance and the collateralized borrowing. It is shown that increasing financial integration has an amplifying effect on the impact of positive, temporary monetary shocks on output, consumption, investment, labor demand and loans. Finally, in the third chapter of the thesis, a government sector that borrows domestically with a partial default risk is integrated into the model in the second chapter in order to analyze the business cycle implications of risk premium shocks in small open economies. Risk premium arises in the economy due to the fact that the lenders to the government, who also have the option of holding foreign securities, have to be compensated for the default risk involved in the government bonds. In response to positive, temporary risk premium shocks, the model predicts an increase in the interest rate on government bonds and in the nominal exchange rate and shows that, depending on the size of the exchange rate depreciation as well as the tax adjustment parameter, the increase in the tax revenue might be such that lower levels of borrowing and higher levels of spending are attainable for the government. It is also shown that the rise in the distorting tax rate creates disincentives to work and thereby causes a fall in labor supply, which in turn leads to a fall in output.