MACROECONOMIC IMPLICATIONS OF
FINANCIAL CONSTRAINTS
1. Credit crunch.
9th set of transparencies for ToCF
INTRODUCTION
GREAT DEPRESSION
 Irving Fisher (EMA 1933): aggrevated by "poor performance" of
financial markets
DEBT DEFLATION
 Friedman-Schwartz (1963): role of money supply.
 Bernanke (1983): breakdown in banking.
BALANCE SHEET CHANNEL
vs
LENDING CHANNEL
Typical pattern:
Recession, high interest rates
weak balance sheets of firms
loan losses + low asset prices reduce equity in financial
sector.
Two sectors (real + financial) are constrained.
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US 1990-91 recession (rather typical)
 banks: reduction in capital ratio
decline in bank lending
 flight to quality

– credit crunch hits poor firms first
– large/healthy firms can go to CP or bond markets.
Same pattern in the wake of a tight money episode (Romer-Romer
BPEA 1990).
Modeling : Apply logic of credit rationing to the two tiers.
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MODEL
BORROWERS ("firms")
Have 1 project / idea each
Investment cost
I
Risk neutral parties
 borrowers (firms)
 monitors (banks)
 investors
Verifiable
0
(failure)
Moral hazard:
return
R
(success)
Versions of the project
good
bad
(low private
benefit)
Bad
(high private
benefit)
Private benefit:
Prob( R)
4
(only good project is viable)
Have assets
Cumulative distribution G(A).
MONITORS
("financial intermediaries", "banks")
can rule out high private benefit bad project of borrower at cost c
(moral hazard).
Total assets of intermediaries = Km.
INVESTORS
uninformed / free riding (actually: implication of the model),
demand expected return
Exogenous
interest rate:
access to "storage
facility" yielding
interest rate i.
Endogenous
interest rate:
savings.
5
EXOGENOUS INTEREST RATE
Equilibrium
Intermediation
6
Certification
7
Intermediation
Bank loan
(on balance sheet).
Certification
Venture capitalist
Lead investment bank
Bankers acceptances
(commercial paper)
Partial securitization of a loan.
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DIRECT FINANCE
Need
where
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INDIRECT FINANCE
10
Because
firm wants to use as little informed capital as possible:
Firm gets financed if it has assets where
is increasing in .
EQUILIBRIUM
M:
11
If interest rate  is endogenous
Supply
imperfectly elastic.
Demand for uninformed capital:
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COMPARATIVE STATICS
3 types of recessions
Lending
channel
Credit crunch
[Intermediaries]
Balance
sheet
channel
Industrial recession
[Firms]
parameter of first
order stochastic
dominance
Classical
recession
Shortage of savings
[Investors]
or
Correlation. Leads and lags
In the three types of capital squeeze, aggregate investment goes
down and
goes up.
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CREDIT CRUNCH
Fact: small firms are prime victims of credit crunch.
[Empirical evidence.]
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VARIABLE INVESTMENT SCALE
A decrease in Km (credit crunch)
solvency ratio of banks
(intermediation)
equity ratio of firms
decreases 
increases 
decreases
increases
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A decrease in Kb (balance sheet channel)
decreases 
decreases 
increases rm
decreases rb
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Description of equilibrium
(1)
inverse function of
(2)
(3)
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r increases with c
High monitoring intensity
high solvency requirements.
 Banks have become low-intensity monitors over the years.
 Finance companies, firms themselves are higher- intensity
monitors
better capitalized.
Intermediation (banks) vs certification (venture capital)
Certifiers have r = 1!
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OTHER RESEARCH PROJECTS
Division of labor between intermediaries and firms, among
intermediaries:
shallow vs deep information.
Dynamics:
 Simultaneous growth of financial and real sectors.
 Increasing share of financial sector. Move toward less intensive
monitoring.
Certification vs intermediation.
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