The Great Recession and Financial Shocks

José-Víctor Ríos-Rull, Consultant

February 2016 | Federal Reserve Bank of Minneapolis Economic Policy Paper 16-3 | With Zhen Huo

A case can be made for the Great Recession being the result of a large financial shock that makes household borrowing difficult. The channel involves large reductions in house prices, which trigger sharp reductions in consumption.

We discuss the ingredients necessary for a quantitative macroeconomic model to successfully implement such a theory. They include: wealth heterogeneity, where the majority of the population needs to acquire financing to purchase houses despite the large amount of wealth in the economy; sizable real frictions that hinder the transformation of consumption into exports and investment and that constrain the increase of household working hours; and a role for expenditures in contributing to productivity.