Interactions of Financial and Real Frictions Along the Business Cycle Stephen P. Millard1,2,4; Alexandra Varadi1; Eran Yashiv3,4 1Bank of England, 2Durham University Business School, 3Tel Aviv University, 4Centre for Macroeconomics (UK) December 2017 REPLACE THIS BOX WITH YOUR ORGANIZATION’S HIGH RESOLUTION LOGO Abstract Key Results We model the interactions of financial frictions and real frictions along the business cycle, using a DSGE model calibrated to the US economy, with heterogeneous households, banks, firms, a housing market, and wage bargaining. The model features labor and investment frictions, in the form of convex costs, and financial frictions, in the form of credit constraints and the risk of banks diversion of funds. In addition, there are price frictions and habits in consumption. We examine technology and monetary policy shocks, as well as credit demand and supply shocks, aiming to determine the consequences of the interactions of real and financial frictions. We identify two main financial market issues at the focus of our analysis: firm borrowing from banks and the leverage and credit spreads characterizing the latter. We link these to gross hiring costs and gross investment costs in a number of channels. We then attempt to disentangle the relative roles played by the various frictions and shocks in this system. We find that both real frictions and firm borrowing operate to mitigate responses to shocks. We are able to show how monetary policy matters for variables of interest to macroprudential policy makers and vice versa. Across all shocks, there are big differences between the model with no borrowing and real frictions and with both. In particular, real frictions matter a lot. Shutting down real frictions, there are differences, sometimes substantial, without and with firm borrowing. Firm borrowing makes a difference given no real frictions, operating to mitigate responses. With real frictions present, does firm borrowing make a difference? For real variables, no. But we do see big differences between them for the financial variables, with borrowing mitigating responses. Firm borrowing takes the economy in the same direction as real frictions. We show below the results for one out of the five shocks we analyze  a credit supply shock (rise in bank diversion risk). The table outlines the differences across specifications, showing the relative roles payed by the different model elements. Credit Supply Shock Worsening of Financial Frictions Main Elements of the Model Baseline: New Keynesian DSGE (Christiano, Eichenabum and Evans, JPE 2005; Smets and Wouters, AER 2007); Firms (in monopolistic competition) face price adjustment costs (Rotemberg, REStud 1982); as well as hiring costs (Merz-Yashiv, AER 2007) and investment adjustment costs (CEE, JPE 2005; Christiano, Eichenbaum and Trabandt, ECMA 2016); Two types of households (HH): patient, who save and lend; impatient who borrow (Iacoviello, RED 2015); both types own housing; Frictional labour market and Nash wage bargaining; Banks receive deposits from patient HH and lend to: a. firms -- to finance investment, wage payments, and hiring costs b. impatient HH; Financial friction (Gertler and Kiyotaki, AER 2015) – risk that bankers divert funds; in eqm. an Incentive Compatibility constraint ensures no diversion; set-up generates endogenous leverage and spread; Central bank -- Taylor (Carnegie-Rochester 1993) rule; Shocks: Technology and monetary policy shocks; shocks to LTV ratio, housing preferences, and credit supply (via bank diversion rate). Banks cut back on lending, as required by depositors, given the greater risk of banks diverting their funds. This leads to a rise in the lending rate and the spread. The real variables react negatively upon impact as does inflation. The central bank lowers the interest rate as a result and so deposits decline. Housing prices drop with the ensuing lower demand for housing. Note the green– blue differences expressing the role of borrowing and the blue-black and green-red differences expressing the role of real frictions.  Doing the same analysis for monetary policy shocks and the LTV ratio (macroprudential policy) shocks, we are able to show how monetary policy matters for variables of interest to macroprudential policy makers and vice versa. Agents in the Model Impulse Response Analysis The key aim is to see the interactions of real and financial frictions. To do so we examine the effects of real, financial, and policy shocks under different model configurations. We shut down key elements pertaining to real and financial frictions in order to determine the relative role played by different parts of the model. Conclusions We find that financial shocks and frictions have implications for the real economy and vice versa. The interactions between financial sector frictions and real frictions matter; both real frictions and firm borrowing operate to mitigate responses to shocks. We denote fraction borrowed to finance investment by Ω₁, the wage bill by Ω₂, and hiring costs by Ω₃. h is the scale of the latter costs and S is a measure of investment costs. Contact Key References Stephen Millard Bank of England Email: stephen.millard@bankofengland.co.uk Website: https://www.bankofengland.co.uk/research/researchers/stephen-millard Phone: +44-20-3461-5845 Christiano, Lawrence J., Martin S. Eichenbaum, and Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy 113, 1, 1-45. Gertler, Mark, and Nobuhiro Kiyotaki, 2015. "Banking, Liquidity, and Bank Runs in an Infinite Horizon Economy," American Economic Review 105(7), 2011--2043. Iacoviello, Matteo, 2015. "Financial Business Cycles," Review of Economic Dynamics 18 (1), 140--163. Merz, Monika and Eran Yashiv, 2007. "Labor and the Market Value of the Firm," American Economic Review 97, 1,419-31. Alexandra Varadi Bank of England Email: Alexandra.Varadi@bankofengland.co.uk Phone: +44-20-7601-3003 Eran Yashiv Tel Aviv University Email: yashiv@post.tau.ac.il Website: http://www.tau.ac.il/~yashiv/ Phone: +972-3-640-9233