Source of the Great Recession

Abstract

We incorporate two structural shocks associated with balance sheets of both the financial and nonfinancial firms in a medium scale New Keynesian dynamic stochastic general equilibrium (DSGE) model. The structural shocks in the model are assumed to possess stochastic volatilities with a leverage effect. Then, we estimated the model using a data-rich estimation method and utilized up to 40 macroeconomic time series. We found the following three pieces of empirical evidence in the Great Recession (Dec. 2007–Jun. 2009) worsened further by the collapse of Lehman Brothers in September 2008. First, the net-worth shock of financial firms had gradually declined prior to a huge decrease of net-worth of nonfinancial firms. Second, the net worth shock of nonfinancial firms accounted for large weight of the business cycles after the Great Recession, in terms of the data-rich approach with the SV of structural shocks, unlike the standard DSGE model. Third, the Troubled Asset Relief Program would have immediately worked to improve balance sheets of financial institutions, although it would not have stopped worsening those of the corporate sector for a while.