A model of slow recoveries from financial crises

Output and productivity fall persistently following financial crises, and innovation efforts also decline in these episodes. After reviewing the evidence, this paper introduces a quantitative macroeconomic model featuring endogenous growth in total factor productivity (TFP) through innovation, in which innovators’ financing is subject to frictions. These frictions become more severe as financial sector balance sheets deteriorate, increasing the cost of credit for innovators and thereby lowering the growth rate of TFP. Key parameters are estimated using data from the South Korean 1997 financial crisis. Financial frictions are found to amplify significantly the medium-run TFP and output losses following the crisis.