1. MACROECONOMIC IMPLICATIONS OF FINANCIAL CONSTRAINTS 1. Credit crunch. 9th set of transparencies for ToCF

2. 2 INTRODUCTION GREAT DEPRESSION Irving Fisher (EMA 1933): aggrevated by "poor performance" of financial markets DEBT DEFLATION Bernanke (1983): breakdown in banking. Friedman-Schwartz (1963): role of money supply. BALANCE SHEET CHANNEL vs LENDING CHANNEL Typical pattern: Recession, high interest rates weak balance sheets of firms loan losses + low asset prices reduce equity in financial sector. Two sectors (real + financial) are constrained.

3. 3 US 1990-91 recession (rather typical) banks: reduction in capital ratio decline in bank lending Same pattern in the wake of a tight money episode (Romer-Romer BPEA 1990). Modeling : Apply logic of credit rationing to the two tiers. flight to quality –credit crunch hits poor firms first –large/healthy firms can go to CP or bond markets.

4. 4 MODEL Have 1 project / idea each Moral hazard: Risk neutral parties borrowers (firms) monitors (banks) investors ("firms") return R (success) Investment cost I Verifiable 0 (failure) (only good project is viable) BORROWERS good bad (low private benefit) Versions of the project Bad (high private benefit) Private benefit: Prob( R)

5. 5 Have assets Cumulative distribution G(A). ("financial intermediaries", "banks") can rule out high private benefit bad project of borrower at cost c (moral hazard). uninformed / free riding (actually: implication of the model), Exogenous interest rate: access to "storage facility" yielding interest rate i. Endogenous interest rate: savings. demand expected return MONITORS INVESTORS Total assets of intermediaries = K m.

6. 6 EXOGENOUS INTEREST RATE Intermediation Equilibrium

7. 7 Certification

8. 8 Intermediation Venture capitalist Lead investment bank Bankers acceptances (commercial paper) Partial securitization of a loan. Bank loan (on balance sheet).

9. 9 Need DIRECT FINANCE where

10. 10 INDIRECT FINANCE

11. 11 Because firm wants to use as little informed capital as possible: Firm gets financed if it has assets where EQUILIBRIUM is increasing in . M:

12. 12 If interest rate  is endogenous Demand for uninformed capital: Supply imperfectly elastic.

13. 13 COMPARATIVE STATICS 3 types of recessions Lending channel Classical recession Balance sheet channel Correlation. Leads and lags In the three types of capital squeeze, aggregate investment goes down and goes up. Credit crunchIndustrial recessionShortage of savings [Intermediaries][Firms] parameter of first order stochastic dominance [Investors] or

14. 14 [Empirical evidence.] Fact: small firms are prime victims of credit crunch. CREDIT CRUNCH

15. 15 VARIABLE INVESTMENT SCALE solvency ratio of banks (intermediation) increases equity ratio of firms A decrease in K m (credit crunch) decreases  increases  decreases

16. 16 A decrease in K b (balance sheet channel) decreases  decreases  increases r m decreases r b

17. 17 (1) Description of equilibrium (2) (3) inverse function of

18. 18 r increases with c Intermediation (banks) vs certification (venture capital) Banks have become low-intensity monitors over the years. Certifiers have r = 1! High monitoring intensity high solvency requirements. Finance companies, firms themselves are higher- intensity monitors better capitalized.

19. 19 OTHER RESEARCH PROJECTS Division of labor between intermediaries and firms, among intermediaries: shallow vs deep information. Simultaneous growth of financial and real sectors. Dynamics: Increasing share of financial sector. Move toward less intensive monitoring. Certification vs intermediation.