Financial Factors in Business Cycles ∗ (Preliminary)

Abstract

We augment a standard monetary DSGE model to include financial markets, and fit the model to EA and US data. The empirical results draw attention to a new shock and to an important new nominal rigidity. The new shock originates in the financial sector and accounts for a significant portion of business cycle fluctuations. We do a detailed study of the role of this shock in the boom-bust of the late 1990s and early 2000s. The new nominal friction corresponds to the fact that lending contracts are typically denominated in nominal terms. Consistent with Fisher (1933), we show that the distributional consequences of this nominal rigidity play an important role in the propagation of shocks. Finally, we exploit the existence of financial variables in our model to investigate the consequences of adopting a monetary policy which reacts to the stock market or to a broad monetary aggregate. ∗ This paper expresses the views of the authors and not necessarily those of the European

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