Financial frictions and the role of investment-specific technology shocks in the business cycle

- The types of shocks that drive the business cycle depend on the modelling framework.
- Adding a collateral constraint to the Smets-Wouters model diminishes role of IST shocks.
- Shocks to the risk premium are found to be key drivers of the business cycle.
- Risk premium shocks account for most of the slowdown in output growth during the GFC.

Shocks affecting the rate at which investment goods are transformed into capital stock have been identified as a major driver of the business cycle. Such shocks have been linked to frictions in financial markets, because financial markets are instrumental in transforming consumption goods into installed capital. Yet we show that the importance of these investment shocks is greatly diminished when collateral constraints on firms are introduced into an estimated dynamic stochastic general equilibrium model. In the presence of binding collateral constraints, risk premium shocks take on a more prominent role as drivers of the business cycle. Modellers of business cycle fluctuations need to be mindful of the incompatibility of investment shocks and collateral constraints and of the difficulty in specifying 'structural' shocks that are robust to modest amendments to the frictions present in a model.