Credit market imperfections and the power of the financial accelerator: A theoretical and empirical investigation

We investigate, both theoretically and empirically, the relationship between credit market imperfections and the degree of shock amplification arising from the so-called financial accelerator. We begin by simulating a dynamic stochastic general equilibrium model with two types of financial frictions-costly contract enforcement and anti-creditor bias in the judicial system. Our model builds on the standard financial accelerator framework of Bernanke et al. (1999), to which we add imperfect judicial enforcement in the line of Krasa and Villamil (2000). According to our simulations, the power of the financial accelerator may either increase or decrease with financial frictions, depending on the source and initial level of such frictions. We then turn to the empirical investigation, based on panel data for 62 countries over 1981-1999. We rely on Djankov et al. (2005) and the World Bank's Doing Business Database for proxies of credit market imperfections. According to our results, which are consistent with the theoretical model's main predictions, macroeconomic volatility and the power of the financial accelerator seem to increase with contract enforcement costs, but vary non-monotonically with the degree of anti-creditor bias in the judicial and legal system.