Real Effects of the Subprime Mortgage Crisis: Is it a Demand or a Finance Shock?

Hui Tong and Shang-Jin Wei

No 14205, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a methodology to study whether and how a financial-sector crisis can spill over to the real economy, and apply it to the case of the ongoing subprime mortgage crisis. If there is a spillover, does it manifest itself primarily by reducing consumer confidence and consumer demand? Is there also a supply-side channel through a tightened liquidity constraint faced by non-financial firms? Since most firms appear to have much larger cash holdings than in the past, some suggest that a liquidity constraint is not likely to be a significant factor for non-financial firms. We propose a methodology to estimate the importance of these two channels for spillovers. We first propose an index of a firm's sensitivity to a shock to consumer confidence, based on its response to the 9/11 shock in 2001. We then construct a separate firm-level index on financial constraint based on Whited and Wu (2006). As a robustness check, we also construct an alternative sector-level index of a firm's intrinsic demand for external finance, based on the work of Rajan and Zingales (1998). We find robust evidence suggesting that both channels are at work, but that a tightened liquidity squeeze appears to be economically more important than reduced consumer confidence or spending in explaining cross-firm differences in stock price declines.

JEL-codes: G1 G3 (search for similar items in EconPapers)
Date: 2008-07
Note: CF IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (54)

Published as Hui Tong & Shang-Jin Wei, 2008. "Real Effects of the Subprime Mortgage Crisis: Is it a Demand or a Finance Shock?," IMF Working Papers, vol 08(186).

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