Asset pricing and the propagation of financial shocks
No 2150, Working Paper Series from European Central Bank
This study augments the neoclassical growth model with a mechanism that creates a novel transmission channel through which financial shocks propagate to the real economy. By affecting agents’ ability to finance consumption expenditures, financial frictions create a demand for safe assets that exposes the economy to asset quality shocks. My main finding is that this mechanism provides a potential explanation for the co-movement observed during the 2007-2009 financial crisis in the eurozone. My results also suggest that these shocks are a plausible source of aggregate risk that could explain business cycle fluctuations as well as standard asset pricing puzzles. Finally, introducing this transmission mechanism into the neoclassical growth model increases the welfare cost of business cycle fluctuations by several orders of magnitude. JEL Classification: E32, E44, G10
Keywords: equity premium puzzle; Great Recession; liquidity constraints (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20182150
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