The Aftermath of the Financial Crisis: The Effect of Deleveraging on the Real Economy

Abstract

This paper seeks to explain the mechanism of transmission of failures from the financial sector to the real economy. We consider the tightening of firms' financial conditions as an engine of such a transmission. In order to investigate this mechanism we construct a dynamic stochastic general equilibrium model focusing on the production side of the economy as a channel of the transition of the crisis. The debt cutting is modeled as a negative shock to the lending mechanism through an increase in the level of collateral required by financial institutions in order to provide a loan. We conclude that deleveraging might be one of the main reasons for the drop in both consumption and investment during the recent financial crisis.