Financial accelerator

The financial accelerator in macroeconomics is the process by which adverse shocks to the economy may be amplified by worsening financial market conditions. More broadly, adverse conditions in the real economy and in financial markets propagate the financial and macroeconomic downturn. The financial accelerator in macroeconomics is the process by which adverse shocks to the economy may be amplified by worsening financial market conditions. More broadly, adverse conditions in the real economy and in financial markets propagate the financial and macroeconomic downturn. The link between the real economy and financial markets stems from firms’ need for external finance to engage in physical investment opportunities. Firms’ ability to borrow depends essentially on the market value of their net worth. The reason for this is asymmetric information between lenders and borrowers. Lenders are likely to have little information about the reliability of any given borrower. As such, they usually require borrowers to set forth their ability to repay, often in the form of collateralized assets. It follows that a fall in asset prices deteriorates the balance sheets of the firms and their net worth. The resulting deterioration of their ability to borrow has a negative impact on their investment. Decreased economic activity further cuts the asset prices down, which leads to a feedback cycle of falling asset prices, deteriorating balance sheets, tightening financing conditions and declining economic activity. This vicious cycle is called a financial accelerator. It is a financial feedback loop or a loan/credit cycle, which, starting from a small change in financial markets, is, in principle, able to produce a large change in economic conditions. The financial accelerator framework has been widely used in many studies during the 1980s and 1990s, especially by Bernanke, Gertler and Gilchrist, but the term “financial accelerator” has been introduced to the macroeconomics literature in their 1996 paper. The motivation of this paper was the longstanding puzzle that large fluctuations in aggregate economic activity sometimes seem to arise from seemingly small shocks, which rationalizes the existence of an accelerator mechanism. They argue that financial accelerator results from changes in credit market conditions, which affect the intrinsic costs of borrowing and lending associated with asymmetric information. The principle of acceleration, namely the idea that small changes in demand can produce large changes in output, is an older phenomenon which has been used since the early 1900s. Although Aftalion's 1913 paper seems to be the first appearance of the acceleration principle, the essence of the accelerator framework could be found in a few other studies previously. As a well-known example of the traditional view of acceleration, Samuelson (1939) argues that an increase in demand, for instance in government spending, leads to an increase in national income, which in turn drives consumption and investment, accelerating the economic activity. As a result, national income further increases, multiplying the initial effect of the stimulus through generating a virtuous cycle this time. The roots of the modern view of acceleration go back to Fisher (1933). In his seminal work on debt and deflation, which tries to explain the underpinnings of the Great Depression, he studies a mechanism of a downward spiral in the economy induced by over-indebtedness and reinforced by a cycle of debt liquidation, assets and goods’ price deflation, net worth deterioration and economic contraction. His theory was disregarded in favor of Keynesian economics at that time. Recently, with the rising view that financial market conditions are of high importance in driving the business cycles, the financial accelerator framework has revived again linking credit market imperfections to recessions as a source of a propagation mechanism. Many economists believe today that the financial accelerator framework describes well many of the financial-macroeconomic linkages underpinning the dynamics of The Great Depression and the ongoing subprime mortgage crisis. There are various ways of rationalizing a financial accelerator theoretically. One way is focusing on principal–agent problems in credit markets, as adopted by the influential works of Bernanke, Gertler and Gilchrist (1996), or Kiyotaki and Moore (1997). The principal-agent view of credit markets refers to the costs (agency costs) associated with borrowing and lending due to imperfect and asymmetric information between lenders (principals) and borrowers (agents). Principals cannot access the information on investment opportunities (project returns), characteristics (creditworthiness) or actions (risk taking behavior) of the agents costlessly. These agency costs characterize three conditions that give rise to a financial accelerator: