Essays on Macroeconomic Consequences of Financial Frictions

Abstract

Considerable empirical evidence has demonstrated strong linkages between the financial sector and the real production sector of an economy. A huge theoretical literature has emerged since 1970s for the understanding of microeconomic origins and macroeconomic consequences of financial frictions. This dissertation presents three theoretical essays on financial frictions and macroeconomic fluctuations.<br /> The first two essays incorporate financial frictions into the real dynamic general equilibrium framework and generate a robust mechanism through which aggregate output responds to productivity shocks in an amplified and hump-shaped fashion. Quadratic capital adjustment costs are assumed in the literature for the modelling of the upward-sloping supply curve of capital goods. However, an "unrealistic" feature of this approach is the persistent deviation of the price of capital from its non-stochastic steady state in the event of an unexpected productivity shock. As an alternative approach, the introduction of financial frictions in the production of capital goods helps capture the empirical fact that the aggregate supply of durable capital goods is rather inelastic in the short run but becomes elastic in the medium run.<br /> The third essay shows that better protection of foreign investors may have uneven welfare implications for different agents. Furthermore, the volatilities of major macroeconomic aggregates are non-monotonic in the degree of foreign investor protection. It helps explain why the empirical literature cannot find a significant relationship between financial openness and macroeconomic volatility.