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CF weekly workshop - Oliver de Groot

When Apr 26, 2011
from 05:00 PM to 06:00 PM
Where Winstanley Lecture Theatre, Trinity College
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** Please note the start time **

Oliver de Groot (Faculty of Economics)

Title: Coordination Failure and Financial Accelerator

This paper studies the effect of short-term uncoordinated creditors in a DSGE model with leveraged borrowers. Creditors (financial intermediaries) receive imperfect signals regarding the profitability of borrowers (entrepreneurs) and, based on these signals and their beliefs about other intermediaries' actions, choose between rolling over and foreclosing on the debt. The global games methodology is employed to determine uniquely the behavior of intermediaries in equilibrium. Due to the uncoordinated actions of intermediaries, the incidence of rollover is suboptimal, generating an illiquidity risk premium on external finance. As entrepreneurs become more leveraged, the size of the inefficiencies increase as do the premiums paid on external finance. In addition, we find that the elasticity of the illiquidity risk premium with respect to leverage is higher when (i) intermediaries are close substitutes for the entrepreneurs, and (ii) when the intra-period illiquidity of capital stock is higher. The interaction between entrepreneurial net worth, leverage and the illiquidity risk premium propagates technology shocks, similar in nature to the financial accelerator. Moreover, the model predicts that persistent illiquidity shocks generate disproportionately severe and long recessions.  Further, we analyze two unconventional policy responses to an illiquidity crisis in credit markets: direct lending and equity injections.

Financial accelerator, Business cycles, Global games, Coordination failure

D82, E32, E44, G12

 

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