Uncertainty Shocks and Balance Sheet Recessions

Uncertainty Shocks and Balance Sheet Recessions

Journal of Political Economy. December
2017, Vol. 125, Issue 6, Pages 2038-2081

 This paper investigates the origin and propagation of balance sheet recessions in a general equilibrium model with financial frictions. I first show that in standard models driven by TFP shocks, the balance sheet channel completely disappears when agents are allowed to write contracts on the aggregate state of the economy. Optimal contracts sever the link between leverage and aggregate risk sharing, eliminating the concentration of aggregate risk that drives balance sheet recessions. I then show how the type of aggregate shock that hits the economy can help explain the concentration of aggregate risk. In particular, I show that uncertainty shocks can drive balance sheet recessions and “flight to quality” events, even when contracts can be written on the aggregate state of the economy. Finally, I explore implications for financial regulation.