Business cycles and the financial propagation mechanism

This dissertation presents a quantitative, general equilibrium, rational expectations model that can account for key aspects of the macroeconomic effects of monetary shocks. Specifically, positive monetary shocks are shown to decrease nominal interest rates and to generate persistent fluctuations in output, asset and goods prices. The model incorporates two financial market frictions: household interperiod portfolio decisions are made prior to the realization of the current period productivity and monetary shocks, and a fraction of firms face endogenously determined collateral constraints on loans used to finance their business activities. The model exhibits many of the stylized facts concerning business cycles: changes in money supply are correlated with changes in output; money appears to lead output over the business cycle; price changes lag changes in real activity; changes in interest rates and output are positively correlated; changes in nominal interest rates are negatively correlated with changes in future output; and measured aggregate productivity is pro-cyclical. The model also eliminates a shortcoming of many business cycle models: the magnitude and persistence of responses to monetary shocks is greatly increased. Finally, the model predicts that monetary policies that consider asset price fluctuations in addition to goods price fluctuations will be more effective at macro-economic stabilization.