325_Lecture25_May2

325_Lecture25_May2 - THE FINANCIAL ACCELERATOR (CONTINUED)...

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1 T HE F INANCIAL A CCELERATOR ( CONTINUED ) M AY 2, 2011 May 2, 2011 2 F INANCIAL A CCELERATOR F RAMEWORK Model Structure ± Four Building Blocks of the Financial Accelerator Framework 1. Firm Profit Function 2. Financing Constraint 3. Government Regulation of Financial Relationships (imposition of R on financing constraint) 4. Relationship between firm profits and dividends 121 1 1 () P kS a R k ± ± ² ± 1 1 P a R k ± ± ± 23 22 2 2 2 2 2 12 2 2 2 2 11 1 1 1 1 1 01 1 21 1 (,) ( ) ( ) 111 1 1 1 Pk Pfk n S Da Pwn Sa Pf k n S D a Pwn Pk iii i i i ³ ³³³ ² ²²³ ³ ³ ² ² ² ³ ³³ ³ ³ ³ = 0 = 0 TODAY
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2 May 2, 2011 3 F IRM P ROFIT M AXIMIZATION Model Analysis ± FOCs with respect to k 2 , a 1 with respect to k 2 : with respect to a 1 : ± Analysis of Equation 4 in isolation ± Answers the central question: under what conditions does NJ = 0? ± Reveals how stock market returns affect financing constraints ± Reveals how government regulation affects financing constraints ± Analysis of Equation 3 and Equation 4 jointly ± Demonstrates how/why financial market prices (i.e., stock prices/returns) matter for macroeconomic activity ± The financial accelerator effect >@ 22 2 2 2 2 2 12 2 2 11 1 1 1 1 1 01 1 21 1 11 1 2 1 (,) ( ) ( ) 111 1 () Pfk n Pk S Da Pwn Pf k n S D a Pwn Pk Sa iii i RS a P k k O ± ±±± ² ²²± ± ± ² ± ±± ± ±³ ³ ² ³ ² 2 2 0 k P PP ii ²± ± ² 0 1 SD SR S i ± ² ³ ³ ± Equation 3 Equation 4 May 2, 2011 4 W HY IS F INANCING A C ONSTRAINT ? Finance Fundamentals ± Two conditions for NJ = 0 ± Market returns on risky assets equal returns on riskless assets ± Risky assets: stocks ± Riskless assets ± Bonds (financial) ± Machines and equipment (physical) – most directly relevant for firms’ production and sales activity ± Basic firm theory prediction: r = mpk 1 1 STOCK rr rR ª º ² ³ « » ± ¬ ¼ The Lagrange multiplier on firm’s financing constraint STOCK 0 Interpretation : if returns on financial assets are aligned with returns on physical assets, financing constraints “don’t matter” Can think of both government bonds (financial assets) and machines & equipment (physical assets) as “riskless”: you (pretty much…) know what you’re going to get from them. Equation 4 Several steps of algebra
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3 May 2, 2011 5 W HY IS F INANCING A C ONSTRAINT ? Finance Fundamentals ± Two conditions for NJ = 0 ± Market returns on risky assets equal returns on riskless assets ± Risky assets: stocks ± Riskless assets ± Bonds (financial) ± Machines and equipment (physical) – most directly relevant for firms’ production and sales activity ± Basic firm theory prediction: r = mpk ± Government oversight of borrowing/lending relationships very lax ± The larger is R , the lower is NJ ± Financing constraint: ± Holding constant market value of financial assets, higher R allows higher k 2 1 1 STOCK rr rR O ª º ± ² « » ³ ¬ ¼ The Lagrange multiplier on firm’s financing constraint STOCK 0 Interpretation : if returns on financial assets are aligned with returns on physical assets, financing constraints “don’t matter” 121 1 1 ()
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This document was uploaded on 11/01/2011 for the course ECON 325 at Maryland.

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325_Lecture25_May2 - THE FINANCIAL ACCELERATOR (CONTINUED)...

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