The Real Effects of Financial Frictions: Amplification, Misallocation, and Instability

Abstract

This dissertation consists of three essays at the intersection of finance and macroeconomics. A common thread is to study the amplification of financial shocks and misallocation due to financial frictions. The first essay studies the role of banks' discretion in managing panics in a dynamic model of credit line run. In downturns, banks tighten liquidity by revoking credit lines. Anticipating this, borrowers run to draw down credit lines in the first place, which imposes further pressure on banks. Thus liquidity rationing and credit line runs form a feedback loop that amplifies bank distress. I fit the model to the U.S. commercial bank data and find that the feedback effects contribute to more than a half of the liquidity contraction during the Great Recession. The second essay is a joint work with Sylvain Catherine, Thomas Chaney, David Sraer, and David Thesmar. We structurally estimate a dynamic model with heterogeneous firms and collateral constraints, based on the causal effect of collateral shocks on firm investment. We then quantify the aggregate impact of financial friction by embedding the model in a general equilibrium framework. The estimates imply that lifting financial frictions would increase welfare by 9.4% and aggregate output by 11%. Half of the output gain is due to an increase in the aggregate stock of capital, one-quarter is due to a larger aggregate labor supply, while the remaining quarter is due to a higher aggregate productivity from a better allocation of inputs across heterogeneous firms. The final essay develops a dynamic general equilibrium model with heterogeneous beliefs and collateral constraints and investigates the cyclicality of haircuts and default risks jointly. The endogenously determined haircuts are countercyclical and thus lead to a downward margin spiral that exacerbates financial instability. Meanwhile, default risks accumulate in the background, until they materialize during crises.