Macroeconomic Effects of Financial Shocks

In this paper we document the cyclical properties of U.S. firms' financial flows. Equity payouts are procyclical and debt payouts are countercyclical. We develop a model with explicit roles for debt and equity financing and explore how the observed dynamics of real and financial variables are affected by `financial shocks', that is, shocks that affect the firms' capacity to borrow. Standard productivity shocks can only partially explain the movements in real and financial variables. The addition of financial shocks brings the model much closer to the data. The recent events in the financial sector show up clearly in our model as a tightening of firms' financing conditions causing the GDP decline in 2008-09. Our analysis also suggests that the downturns in 1990-91 and 2001 were strongly influenced by changes in credit conditions.