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A Simple Financial Accelerator in a Standard Macro-Econometric Model Statistiques Working Papers Du STATEC N° 101 Juillet 2018

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A Simple Financial Accelerator in a Standard Macro-Econometric Model Statistiques Working Papers Du STATEC N° 101 Juillet 2018 N° 101 Juillet 2018 A simple financial accelerator in a Auteurs: Ferdy ADAM (STATEC) et Christian standard macro-econometric model GLOCKER (Wifo) * Abstract Nowadays quite common in DSGE models, the linkages between the real and the financial sectors are usually absent in traditional macro-econometric models, used for forecasting and policy analysis. This work introduces a so called «financial accelerator» into a standard estimated macro-model, called Modux, representing the Luxembourgish economy. These linkages have been introduced both for machinery and equipment investment and residential investment. The present paper aims at bringing both extensions together in a recently re-estimated version of Modux. Model simulations show that the inclusion of the financial accelerator replicates the stylized facts of the literature (cycle amplification) and might also help to better design standard real demand multipliers. The financial accelerator also proves to be a useful tool to improve the forecasting performance of a general macro-econometric model, the more so in times of financial stress. Keywords: macroeconometric modelling, financial accelerator, public spending multipliers, financial crises JEL Codes: E17; E51; E63; G01 * The authors wish to thank above all the members of STATEC’s forecasting and modelling Division CMP for valuable comments, as well as Profs. M. Marcellino and L. Fontagné and some anonymous participants at Ecomod 2018 conference. Les articles publiés dans la série "Économie et statistiques" n'engagent que leurs auteurs. Ils ne reflètent pas forcément les vues du STATEC et n'engagent en rien sa responsabilité. Economie et A simple financial accelerator in a standard macro-econometric model Statistiques Working papers du STATEC N° 101 juillet 2018 2 Introduction Standard macroeconomic models usually assume perfect capital markets where there is no role for interactions between real and financial factors. The Global Financial Crisis of 2007–2009 however highlighted the extent to which fluctuations in asset prices, credit and capital flows can have dramatic impacts on the financial position of households, corporations and sovereign alike, and therefore on the real economy. The aim of this paper is to summarize how such interactions work through in a standard estimated macro-econometric model Modux, representing the Luxembourgish economy (see Adam 2004 and 2007). The theoretical foundations for the incorporation of these relations have been developed over the past three decades. Bernanke and Gertler (1989) is an early study in this respect. Kiyotaki and Moore (1997) provide another approach to adding financial interactions in a model of the macroeconomy. It this literature, three possible channels of interactions between the financial and the real sides are distinguished: • From the real economy to the financial markets: recessions impact the lending/borrowing behaviour of banks (mostly in terms of risk taking); • Amplification (by financial frictions): when financial frictions (i.e. imperfections) are prevalent, financial markets do not work smoothly, and the magnitude of the feedback loop between the real sector and the financial sector gains importance; • Financial shocks (which impact the real economy): because of disruptions in financial markets, fewer funds can be channelled from lenders to borrowers, and the real economy is impacted. Those channels have been integrated into Modux, the macro econometric model of STATEC, by means of simple relations, however derived from theory, and based on econometric analysis. Corresponding work has been published in two STATEC Working papers (Glocker 2016 and 2017): Glocker (2016) estimates a financial accelerator mechanism for machinery and capital investment whereas Glocker (2017) does the same for housing investment. The aim of this paper is to bring both extensions together and to present model simulations in order to illustrate the importance of the (new) transmissions channels between the real economy and the financial sector. For this purpose, shock simulations are undertaken and compared with and without “financial accelerator”. Main results are as follows: - whole model simulations with financial accelerator (scenario analysis) remain meaningful, i.e. the model stabilises, however over a short period only (5 years); - comparisons of results with and without financial accelerator confirm stylized facts found in related research, i.e. - amplification (shocks with financial accelerator are magnified); - oscillation (shocks with financial accelerator present more pronounced cycles); - one additional finding is that classic public demand multipliers with financial accelerator also increase, in line with a vast literature on the importance of Keynesian multipliers in times of financial stress (see for ex. Corsetti et al., 2012); - the forecast performance of the financial accelerator model seems to beat the standard model in terms of dispersion and accuracy in about 75% of the variables tested. In the remainder of the paper, we will first present the literature review and the theoretical relations that have been estimated, followed by the summarized econometric results. Details are in the appendix. In a final part we will exhibit shock simulations both with and without financial accelerator, in order to emphasize the role and the importance of the latter in the workings of the macro model, before summing up the work done on forecasting properties. A simple financial accelerator in a standard macro-econometric model Economie et Statistiques Working papers du STATEC N° 101 juillet 2018 3 1. Literature review 1.1 Theoretical aspects1 The financial accelerator (or credit multiplier) explicitly interconnects financial markets and the real economy in an environment which is characterized by incomplete capital markets. An important result from the literature on the credit channel is that under the presence of information asymmetries, firms are likely to finance investment projects using internal funds (for instance retained earnings) rather than drawing on external finance. Put differently, external finance is more costly than internal finance. This difference is called the external finance premium, which is essentially a mark-up over the price of internal finance. This premium arises due to various frictions, as for instance, external lenders cannot perfectly observe nor control the risks that a project inherits under which a bank supplies funds to borrowers. Hence lenders require a compensation for the expected agency costs. The key innovation in financial accelerator models is that they embed the problem of information asymmetries in a standard macroeconomic model. The key variable in these models is the net worth of borrowers, which is accumulated by means of retained earnings. Shocks to net worth relative to total finance requirements generate endogenous changes in agency costs and in the finance premium for external funds which are charged above risk-free rates. In this set-up, any structural shock is likely to be amplified relative to a model set-up where the financial accelerator extension is omitted. Over the past three decades, rigorous analytical models have investigated the linkages between financial markets and the real economy. There is also a well-established series of publications in macroeconomics concerning the incorporation of financial market frictions (i.e. market imperfections) in standard macroeconomic models. Bernanke and Gertler (1989) is an early study in this respect. Kiyotaki and Moore (1997) provide another approach to adding financial frictions in a general equilibrium model of the macro economy. Standard macroeconomic models, though, usually embed the Modigliani-Miller assumption about perfect capital markets. Hence there is no theoretical role for modelling the interactions between real and financial factors. The Global Financial Crisis of 2008–09 highlighted the extent to which fluctuations in asset prices, credit and capital flows can have a dramatic impact on the financial position of households, corporations and sovereign alike and by this, violating the Modigliani-Miller assumption. In this context, the crisis has brought back in mind the importance surrounding macro-financial linkages; however, it is yet only another incident highlighting the importance of real and financial linkages. It is convenient to distinguish three possible channels linking financial flows and real economic activity: • From the real economy to the financial markets: If this were the only linkage between real and financial flows, the explicit modelling of the financial sector would be of limited relevance for understanding movements in real economic activities. • Amplification: This hypothesis states that financial frictions exacerbate a recession, however, they are not considered as the cause of the recession. In this context, something wrong happens in the real sector in the first place. This could be caused by exogenous shocks to productivity, the terms-of-trade, monetary aggregates, interest rates, preferences, etc. These structural innovations would trigger a macroeconomic contraction even in the absence of financial market frictions. When financial frictions are prevalent, however, i.e. financial markets do not work smoothly, the magnitude of the contraction becomes more pronounced. Therefore, financial frictions amplify the macroeconomic impact of the exogenous changes. 1 For an excellent and recent review of the literature: Claessens & Kose (2018):
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