The High Sensitivity of Economic Activity to Financial Frictions

A financial friction is a wedge between the return received by providers of financial capital—ultimately, consumers—and the cost of capital paid by businesses and consumers who use capital. I study two frictions. One raises the rental cost of capital to firms and the other raises the rental cost of housing and durable goods to consumers. My focus is on the effects of financial frictions—I take the magnitudes of the frictions as given. Thus my results complement an active recent literature that explains the intensification of financial frictions in a crisis. I find that financial frictions are powerful determinants of economic activity. This version for reading in color