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January 2009 - March 2010

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University of Minnesota Twin Cities
College of Liberal Arts
Department of Economics

PI: Cristina Arellano
Co-PI: Patrick J. Kehoe

Financial Crises and Fluctuations in Uncertainty

Recent empirical work has documented that recessions are times in which the cross section dispersion of productivity shocks across firms rise. In a standard model with complete markets such an increase in dispersion has no effect on aggregate output. These researchers are exploring a model with three key ingredients. First, the loans to firms cannot depend on their idiosyncratic shocks. Second, firms must choose the scale of their projects in advance. Third, firms can default if they have insufficient funds to pay for their debt. The parameters of the model are calibrated to be consistent with several features of the micro data on firms. A quantitative version of this model can generate aggregate fluctuations even though the only shocks are to the cross section dispersion of productivities. When this dispersion is high, firms optimally choose to contract the size of their projects in order to avoid default. Such a contraction resembles a credit crisis with low amounts of credit to firms.

This model is requires high computing power because the researchers need to record the cross section distribution of firms’ assets and planned size of projects in a model with aggregate shocks in a model with default, entry, and exit. Indeed, this may be the first research to do so.