Working Papers

[PDF] “Macroeconomic Transmission of Financial Crises: A Story of Aggregate Demand” (Job Market Paper)

How do financial crises fuel protracted episodes of muted labor demand?  The 2008 Financial Crisis caused a significant and long-lasting contraction in employment as firms persistently curbed their demand for labor. To rationalize such an extraordinary real response to financial crises, contemporary macroeconomic theory predominantly appeals to mechanisms of aggregate supply. In contrast, since anecdotal evidence suggests that the Great Recession was primarily fueled by a slump in consumer demand, I propose a macroeconomic framework in which financial crises cause real contractions via aggregate demand. In the model, financial crises arise when broker-issued margin calls force institutional investors — pension funds who allow households to indirectly hold claims in firms — to liquidate assets in a fire sale. Since fire sales occur at prices below fundamental values, they cause potentially substantial losses in nominal household wealth. To restore their retirement savings, households react to fire sales by reducing nominal consumer spending. As households voluntarily substitute away from consumption towards savings, the described wealth effect view of the Great Recession presents a natural alternative to the recently challenged household leverage view, which can only account for the observed slow recovery, but not the abrupt and deep initial downturn. In response to the sudden slump in aggregate demand, firms scale back employment and investment because worker effort is sensitive to nominal wage cuts. The resulting collapse of the capital stock causes a protracted depression of labor productivity and, in turn, a long-lasting labor market hysteresis. Since the real contraction’s severity and longevity increases in the size of the initial nominal collapse, my framework rationalizes the conventional wisdom that in face of an ongoing financial crisis, central banks ought to intervene swiftly and aggressively.