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Financial frictions and fluctuations in volatility

Author

Listed:
  • Cristina Arellano
  • Yan Bai
  • Patrick J. Kehoe

Abstract

During the recent U.S. financial crisis, the large decline in economic activity and credit was accompanied by a large increase in the dispersion of growth rates across firms. However, even though aggregate labor and output fell sharply during this period, labor productivity did not. These features motivate us to build a model in which increased volatility at the firm level generates a downturn but has little effect on labor productivity. In the model, hiring inputs is risky because financial frictions limit firms' ability to insure against shocks that occur between the time of production and the receipt of revenues. Hence, an increase in idiosyncratic volatility induces firms to reduce their inputs to reduce such risk. We find that our model can generate about 67% of the decline in output of the Great Recession of 2007–2009.

Suggested Citation

  • Cristina Arellano & Yan Bai & Patrick J. Kehoe, 2012. "Financial frictions and fluctuations in volatility," Staff Report 466, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmsr:466
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    References listed on IDEAS

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    More about this item

    Keywords

    Recessions ; Credit;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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