Hysteresis effects and financial frictions

In the aftermath of the 2008 financial crisis, production and employment in advanced economies fell significantly, and remained below their pre-crisis potential level for almost a decade. A recent literature argues that market forces seem to have maintained or amplified this downward trend through hysteresis effects. Particularly intuitive arguments about the emergence of hysteresis effects through financial friction are provided by this literature. However, based on the current state of our knowledge, the theoretical models on hysteresis disregard this important dimension to the understanding of hysteresis. This article contributes to the literature by developing a New-Keynesian model where financial frictions amplify the lingering effects of economic shocks. By calibrating the model on the euro area, the results show that a deterioration of bank capital following a capital quality shock similar to the crisis of high-risk loans generates both persistence and more severity in the fall of production and in the rise of unemployment— more so than the classical models of hysteresis. The impact of shocks is magnified due to the reduction of physical capital in response to a weakening of the financing capacity of investment projects by the banking sector.