Financial accelerator
Encyclopedia
The financial accelerator in macroeconomics refers to the idea that adverse shocks to the economy may be amplified by worsening financial market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...

 conditions. More broadly, adverse conditions in the real economy and in financial markets mutually reinforce each other, leading to a feedback loop that propagates the financial and macroeconomic downturn.

Financial Accelerator Mechanism


The link between the real economy and financial markets stems from firms’ need for external finance to engage in profitable investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

 opportunities. On the other hand, firms’ ability to borrow largely depends on the market value of their financial and tangible assets (net of their liabilities), in other words their net worth
Net worth
In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...

. The reason for this is the familiar story of asymmetric information. Since lenders are likely to have little information about the creditworthiness of a borrower, they often require borrowers to set forth their ability to repay, which may take the form of collateralizing their assets. Thus, a fall in asset prices that is induced by an initial shock deteriorates the balance sheets of the firms in the sense that their net worth
Net worth
In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...

 worsens and their ability to borrow declines. Tightening financing conditions limit their investment, which in turn reduces their economic activity or output. Finally, decreased economic activity further cuts the asset prices down, which leads to a feedback cycle of falling asset prices, deteriorating balance sheets, tightening financing conditions and declining economic activity. This vicious cycle is called a financial accelerator, a financial feedback loop or a loan/credit cycle .

History of Acceleration in Macroeconomics

Financial accelerator framework has been widely used in many studies during 1980s and 1990s, especially by Bernanke (the Chairman of the Federal reserve), Gertler and Gilchrist , but the term “financial accelerator” has been introduced to the macroeconomics literature in their 1996 paper . The motivation of this paper was the longstanding puzzle that large fluctuations in aggregate economic activity sometimes seem to arise from seemingly small shocks, which rationalizes the existence of an accelerator mechanism. They argue that financial accelerator results from changes in credit market conditions, which affect the intrinsic costs of borrowing and lending associated with asymmetric information.

The principle of acceleration, namely the idea that small changes in demand can produce large changes in output, is an older phenomenon which has been used since the early 1900s. Although Aftalion’s 1913 paper seems to be the first appearance of the acceleration principle, the essence of the accelerator framework could be found in a few other studies previously .

As a well known example of the traditional view of acceleration, Samuelson (1939) argues that an increase in demand, for instance in government spending, leads to an increase in national income, which in turn drives consumption and investment, accelerating the economic activity. As a result, national income further increases, multiplying the initial effect of the stimulus through generating a virtuous cycle this time.

The roots of the modern view of acceleration go back to Fisher (1933). In his seminal work on debt and deflation, which tries to explain the underpinnings of the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

, he studies a mechanism of a downward spiral in the economy induced by over-indebtedness and reinforced by a cycle of debt liquidation, assets and goods’ price deflation, net worth
Net worth
In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...

 deterioration and economic contraction. His theory was disregarded in favor of Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 at that time.

Recently, with the rising view that financial market conditions are of high importance in driving the business cycles, financial accelerator framework has revived again linking credit market imperfections to recessions as a source of a propagation mechanism. Many economists believe today that financial accelerator framework describes well many of the financial-macroeconomic linkages underpinning the dynamics of The Great Depression and the ongoing subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

.

A Simple Theoretical Framework

There are various ways of rationalizing a financial accelerator theoretically. One way is focusing on principal-agent problems in credit markets, as adopted by the influential works of Bernanke, Gertler and Gilchrist (1996) or Kiyotaki and Moore (1997).

The principal-agent view of credit markets refers to the costs (agency costs) associated with borrowing and lending due to imperfect and asymmetric information between lenders (principals) and borrowers (agents). Principals cannot access the information on investment opportunities (project returns), characteristics (creditworthiness) or actions (risk taking behavior) of the agents costlessly. These agency costs characterize three conditions that give rise to a financial accelerator:
  1. External finance (debt) is more costly than internal finance (equity) unless it is fully collateralized, by which agency costs disappear as a result of guaranteed full repayment.
  2. The premium on external finance increases with the amount of finance required but given a fixed amount of finance required, premium inversely varies with the borrower’s net worth, which signals ability to repay.
  3. A fall in borrower’s net worth reduces the base for internal finance and raises the need for external finance at the same time raising the cost of it.


Thus, to the extent that net worth is affected by a negative (positive) shock, the effect of the initial shock is amplified due to decreased (increased) investment and production activities as a result of the credit crunch (boom).

The following model simply illustrates the ideas above:

Consider a firm, which possesses liquid assets such as cash holdings (C) and illiquid but collateralizable assets such as land (A). In order to produce output (Y) the firm uses inputs (X), but suppose that the firm needs to borrow (B) in order to finance input costs. Suppose for simplicity that the interest rate is zero. Suppose also that A can be sold with a price of P per unit after the production, and the price of X is normalized to 1. Thus, the amount of X that can be purchased is equal to the cash holdings plus the borrowing
X = C + B.


Suppose now that it is costly for the lender to seize firm’s output Y in case of default; however, ownership of the land A can be transferred to the lender if borrower defaults. Thus, land can serve as collateral. In this case, funds available to firm will be limited by the collateral value of the illiquid asset A, which is given by
B ≤ P A


This borrowing constraint induces a feasibility constraint for the purchase of X
X ≤ C + P A.


Thus, spending on the input is limited by the net worth
Net worth
In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...

 of the firm. If firm’s net worth is less than the desired amount of X, the borrowing constraint will bind and firm’s input will be limited, which also limits its output.

As can be seen from the feasibility constraint, borrower’s net worth can be shrunk by a decline in the initial cash holdings C or asset prices P. Thus, an adverse shock to a firm’s net worth (say an initial decline in the asset prices) deteriorates its balance sheet through limiting its borrowing and triggers a series of falling asset prices, falling net worth, deteriorating balance sheets, falling borrowing (thus investment) and falling output. Decreased economic activity feeds back to a fall in asset demand and asset prices further, causing a vicious cycle.

Welfare Losses and Government Intervention : An Example from the Subprime Mortgage Crisis

We have been experiencing the welfare consequences of the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

, in which relatively small losses on subprime assets have triggered large reductions in wealth, employment and output. As stated in Krishnamurthy (2009), the direct losses due to household default on subprime mortgages are estimated to be at most $500 bn, but the effects of the subprime shock have been far reaching. In order to prevent such huge welfare losses, governments may intervene in the financial markets and implement policies to mitigate the effects of the initial financial shock. For the credit market view of the financial accelerator, one policy implementation is to break the link between borrower’s net worth and its ability to borrow as shown in the figure above.

There are various ways of breaking the mechanism of a financial accelerator. One way is to reverse the decline in the asset prices. When asset prices fall below a certain level, government can purchase assets at those prices, pulling up the demand for them and raising their prices back. The FED was purchasing mortgage-backed securities in 2008 and 2009 with unusually low market prices. The supported asset prices pulls the net worth of the borrowers up, loosening the borrowing limits and stimulating investment.

Financial Accelerator in Open Economies

The financial accelerator also exists in emerging market crises in the sense that adverse shocks to a small open economy may be amplified by worsening international financial market conditions. Now the link between the real economy and the international financial markets stems from the need for international borrowing; firms’ borrowing to engage in profitable investment and production opportunities, households’ borrowing to smooth consumption when faced with income volatility or even governments’ borrowing from international funds.

Agents in an emerging economy often need external finance but informational frictions or limited commitment can limit their access to international capital markets. The information about the ability and willingness of a borrower to repay its debt is imperfectly observable so that the ability to borrow is often limited. The amount and terms of international borrowing depend on many conditions such as the credit history or default risk, output volatility or country risk, net worth or the value of collateralizable assets and the amount of outstanding liabilities.

An initial shock to productivity, world interest rate or country risk premium may lead to a “sudden stop” of capital inflows which blocks economic activity, accelerating the initial downturn. Or the familiar story of “debt-deflation” amplifies the adverse effects of an asset price shock when agents are highly indebted and the market value of their collateralizable assets deflates dramatically.
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