Financial Frictions, Asset Prices, and the Great Recession

José-Víctor Ríos-Rull, Consultant

February 2016 | Federal Reserve Bank of Minneapolis Staff Report 526 | With Zhen Huo

We study financial shocks to households’ ability to borrow in an economy that quantitatively replicates U.S. earnings, financial, and housing wealth distributions and the main macro aggregates. Such shocks generate large recessions via the negative wealth effect associated with the large drop in house prices triggered by the reduced access to credit of a large number of households. The model incorporates additional margins that are crucial for a large recession to occur: that it is difficult to reallocate production from consumption to investment or net exports, and that the reductions in consumption contribute to reductions in measured TFP.