Financial frictions and the welfare effect of business cycles

ABSTRACT

This paper studies the implications of financial frictions on the welfare effects of business cycles, using the agency cost model of Carlstrom and Fuerst (1997). We decompose the total welfare effects of business cycles into the fluctuation and mean effect. We find that whether financial frictions reduce the total welfare or not, for any given shock, depends on the size of the mean effect. The presence of financial frictions reduces the mean effect and thus the welfare in response to aggregate productivity shocks, whereas it increases the mean effect in response to net worth shocks.

KEYWORDS:

• Welfare cost of business cycles
• financial frictions
• investment
• mean effect

JEL CLASSIFICATION:

• E32
• E44

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ See Gertler and Gilchrist (2017) for the literature survey.

² That is, we compute $4\times \frac{\mathrm{\Delta }c}{c}$, where $\frac{\mathrm{\Delta }c}{c}$ satisfies the restriction.