The Geography of Financial Frictions

This paper studies the aggregate implications of the geography of financial frictions faced by firms in Europe. Using proprietary data from the European Central Bank's Survey on the Access to Finance of Enterprises, we document three new facts. First, there is substantial regional heterogeneity in the access to external finance. Second, this heterogeneity is persistent, with only gradual convergence over time. Third, countries with tighter financial frictions are less responsive to monetary shocks. To formalize these empirical findings, we develop and calibrate a tractable New~Keynesian model of a monetary union with 22 countries that are heterogeneous in financial frictions, productivity, and size. High-friction countries are less responsive to monetary shocks because firms face a steeper marginal cost curve and a lower capital elasticity. The heterogeneity in financial frictions also shapes the output-inflation trade-off, as in high-friction countries the same output gain comes at the cost of more inflation. Convergence experiments show that financial market integration in the spirit of a European Savings and Investments Union raises the power of monetary policy, but at a potential cost to financial stability.