The implications of dynamic financial frictions for DSGE models

This paper shows that when financial frictions are dynamically modeled, broader inferences can be drawn from DSGE models with asymmetric information costs. By embedding a partial equilibrium framework of bankruptcy proceedings in a dynamic New Keynesian model I find, for example, that financial liberalization episodes are only effective in countries with an efficient judicial system. More generally, I find that the response of output to various shocks depends on the duration of bankruptcy proceedings. These relationships, however, are not strictly unidirectional. The responses to adverse shocks are amplified (mitigated) when the shocks also generate an increase (a decrease) in real interest rates and an increase (decrease) in the stock of bankruptcy cases. I find empirical support for one prediction of the model by investigating macroeconomic and foreclosure data from U.S. states; monetary policy is more effective in states that have longer foreclosure proceedings.