Abstract
This thesis examines the implications of financial frictions on macroeconomic outcomes and their impact on the transmission mechanisms of economic policy. Chapters 3 and 4 study the theoretical implications of significant non-linearities in financial constraints, chapter 5 examines the role of financial frictions on cross-border lending in a currency union. Macroeconomic time-series suggest that occasional financial crises generate sharp increases in the interest spread, and deep downturns in output and investment. Standard models of financial frictions are unable to explain this phenomena as the implied borrowing constraints are always binding. In chapter 3, a model is proposed in which the financial constraints are only occasionally binding. This generates simulated time series that capture these crisis episodes, and, as a result, replicate observed positive skewness in the interest spread, and negative skewness in output and investment. The majority of models of financial frictions, including that proposed in chapter 3, focus on a time-varying investment wedge between the risky return to capital and the risk-free rate. The empirical evidence, however, suggests that this wedge does not play an important role in driving business cycles, but rather supports financial frictions that affect either the efficient allocation of the factors of production (efficiency wedge), or the labour market (labour wedge). In chapter 4 I propose a model where a credit friction emerges as both an efficiency and investment wedges. This is able to generate occasional, large crisis episodes and replicate the observed negative skewness in simulated time series of output and investment. Contrary to empirical evidence, cross-border financial flows in structural models usually dampen the adverse effects of shocks. In chapter 5, I examine frictions in the cross-border interbank market in a currency union that enhance these effects. Two recently applied unconventional policies are implemented and analysed.