Staff Report 466

Financial Frictions and Fluctuations in Volatility

Cristina Arellano | Assistant Director and Monetary Advisor
Yan Bai
Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis

Revised November 27, 2018

Abstract
The U.S. Great Recession featured a large decline in output and labor, tighter financial conditions, and a large increase in firm growth dispersion. We build a model in which increased volatility at the firm level generates a downturn and worsened credit conditions. The key idea is that hiring inputs is risky because financial frictions limit firms' ability to insure against shocks. An increase in volatility induces firms to reduce their inputs to reduce such risk. Out model can generate most of the decline in output and labor in the Great Recession and the observed increase in firms' interest rate spreads.

RELATED PAPER: Staff Report 538: Appendix for Financial Frictions and Fluctuations in Volatility



Forthcoming In: Journal of Political Economy

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