Financial Frictions and the Role of Investment Specific Technology Shocks in the Business Cycle

Various papers have identified shocks to investment as major drivers of output, investment, hours, and interest rates. These investment shocks have been linked to financial frictions because financial markets are instrumental in transforming consumption goods into installed capital. However, the importance of investment shocks is not robust once we explicitly account for a simple financial friction. We estimate a medium scale dynamic stochastic general equilibrium model with collateral constraints. When entrepreneurs are subject to binding collateral constraints, a reduction in the value of installed capital reduces the value of collateral and thus the amount an entrepreneur can borrow. As a result, aggregate consumption no longer co-moves with GDP and the response of investment to a positive investment shock is attenuated. In the model with collateral constraints, the role of risk premium shocks in the business cycle increases markedly, whereas investment shocks have a much diminished role.