Question
We show that four shocks can account for the key features of the Great Recession. Two of these shocks capture in a reduced form
We show that four shocks can account for the key features of the Great Recession. Two of these shocks capture in a reduced form way frictions which are widely viewed as having played an important role in the Great Recession. The first of these is motivated by the liter- ature stressing a reduction in consumption as a trigger for a zero lower bound (ZLB) episode (see Eggertsson and Woodford (2003), Eggertsson and Krugman (2012) and Guerrieri and Lorenzoni (2012)). For convenience, we capture this idea as in Smets and Wouters (2007) and Fisher (2014), by introducing a perturbation to agents' intertemporal Euler equation govern- ing the accumulation of the risk-free asset. We refer to this perturbation as the consumption wedge. The second friction shock is motivated by the sharp increase in credit spreads observed in the post-2008 period. To capture this phenomenon, we introduce a wedge into households first order condition for optimal capital accumulation. Simple financial friction models based on asymmetric information with costly monitoring imply that credit market frictions can be captured in a reduced form way as a wedge in the household's first order condition for capital (see Christiano and Davis 2006). We refer to this wedge as the financial wedge. Also, motivated by models like e.g. Bigio (2013), we allow the financial wedge to impact on the cost of working capital.
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