The Basics of Financial Accelerator Models

The interaction between borrowing constraints, asset prices, and aggregate production has always been linked to the financial sector's performance. When things are going on well, and the market is stable, it becomes much easier to look at the existing condition where borrowers and lenders interact. Despite the global financial market being equipped with vast experience and lessons from the past economic issues, it is not left from financial crises. When economic failures occur, the industry is often the worst hit. Financial crises happened when assets used to secure borrowed money lose their value abruptly. It is a condition that affects the whole economy when it happens.

A financial accelerator 

Sometimes financial market crises do not have any major impact on the main economy. It could end with the affected markets who find other means of recovering. However, other situations affecting financial markets may amplify the effects of changes in the real economy. This is called a financial accelerator. It also means the conditions in the financial markets and the economy may support each other, a situation that causes a feedback loop that gives out a boom or bust when the conditions are very insignificant at individual levels. When individual issues are examined critically, it does not seem to pause any threat to the economy. But when there are many factors, and extend into other areas of an economy, it becomes difficult to about a financial accelerator.

This idea is majorly linked to the Federal Reserve Board Chairman, Ben Bernanke, together with economist Mark Gertler and Simon Gilchrist. Other economists and financial markets analysts have come up with different versions of the situation, but it always remains the same. Financial crises have become part of modern economies. It is not something that can be easily controlled, and stakeholders in the industry have come to terms with the fact that nothing can stop them. Various analyses have tried coming up with ideas on how they occur and how they can be avoided, but it all leads to nothing because the effects are still eminent.

A financial accelerator on many occasions from a credit market and spreads slowly into the entire economy. This should be easy to understanding, especially since it is the financial markets, more so the credit market that forms the largest part of economic development. Hence an accelerator comes from and extends through it. Note also, that a financial crisis can either initiate and increase both positive and negative shocks on a macroeconomic setup. This means we don't always have to look at it as a negative force, but also as one that can initiate some positive results.

Using the financial accelerator model 

It is not easy to understand or explain why and how small changes in the monetary policy or credit environment many have such a huge impact on the real economy. And his is where the financial accelerator model comes in. It is used to establish and explain how even small changes can significantly impact the general economy. By doing so, economists seek to understand governments and intermediaries' role, when there is a boom or a burst in the economy. Studying this model is critical because we have seen just how much economic growth depends on financial markets' success.

Most of the economic crises in history have been linked to the financial markets. Consider the 2009 Great Depression, for instance. It all began with an economic bubble in the housing industry where the assets we valued at luring price. Banks and other financial institutions rushed to take advantage of the situation by offering loans without doing a proper background check on the borrowers. When the assets lost their value abruptly, it was a devastating moment for the financial market. It led to the biggest failures of all times, affecting the whole world. A financial accelerator can augment such a condition.

The aim of proposing a financial accelerator was to help explain why these changes, however small they are, could have adverse effects on the real economy. It is always fascinating how something unexpected can grow from something very simple. It is also important for students undertaking economic studies to understand how some of these things happen. The effects flow down to company and individual consumer decisions. For instance, a relatively small change in the prime rate can make firms and consumers slash spending even if only a small increase in cost. Human beings are rational decision-makers, and they will always consider the existing conditions and how they benefit from taking one product over the other before settling on the right one. This is why any changes in the expenditure are taken very seriously. 

Business cycles are part of the modern economy. There will always be bubbles peaks and troughs within an economy. The financial accelerator theory comes up with a proposition that, at the peaks of the business cycle, the vast number of firms and individuals have overstretched themselves to different degrees. In other words, they have not taken any cheap debt to finance growth or expansion of their business or personal lifestyle. It is no longer a situation where taking a loan is simple. At the same time, these consumers are also very sensitive about changes in the credit environment, compared to other points in the business cycle. The cycle will soon come to an end, which presses the overstretched majority due to poor economy and tightening credits. 

The Great Recession

The effect in credit conditions on the economy does is not very new. Many economists from tried since the beginning to explain these occurrences and perhaps try to avoid their impacts. However, Bernanke, Gertler, and Gilchrist's model is more modern and includes a better tool for guiding policy when effecting the credit market impacts. It is true that there is nothing anyone can do to stop the economic fluctuations that affect markets, but that does not mean markets should just sit back and wait for the effects to worse.

Despite the financial accelerator being around for a long time, and especially through the former economic crises, it was not until 2008 that it was taken into account. At the moment, Bernanke was at the center of the Feds when the financial crisis turned into the Great Recession. Then, the financial accelerator model became very popular among many analysts. It was the most useful approach that offered the context of explaining why the Fed took certain actions to minimize feedback loops or shorten how long they were going to run.

Again, this became a major reason many of the bailout measures, as many knew them then, took focus on stabilizing the credit markets, directly through the banks. Slowed credit causes a flight to quality when a financial accelerator model is considered. In other words, weaker firms are left to struggle by themselves, which leads to the fall of many, whereas stronger ones receive a credit to sustain their operation. It is more like the survival for the fittest, a situation that is far too common whenever financial crises happen, and the 2008 situation was only an eye-opener that firms have to be vigilant of economic bubbles. However, more of the firms continue struggling with consumer-driven buying, while falling out of favor as well. The loop just keeps worsening until there is no more credit in the economy, creating more pain for the economy. Bernanke had already accumulated a lot of knowledge on financial accelerators, which he used while trying to ease the pain and short the credit conditions time for the U.S economy. As a major player in the global economy, it encouraged many other economies to take the same approach since the effect was global.  

The Main Pillars of the Financial Accelerator Model

Before looking at four main pillars of the accelerator model, it will be prudent to discuss the characteristics of the two types of assets crucial to the model. Their risk properties mainly differentiate these assets. On one side of the model, we have the riskless assets, which include short-term government bonds and the marginal product of capital. On the other hand, they are risky assets, which are considered more problematic, and they are the most in any economy.

Risk can be defined as the 'guarantee' about an asset's value in terms of payoff sometime in the future. In the financial industry, the asset should have a fixed date in the future. A riskless asset is one whose risk value is certain, now and in the future, and market participants know what to do with it. Also, the risky asset is one with less value on a guarantee.

Even though some assets are considered riskless, there is no asset that is true without risk. However, it is still important to consider the definition because it helps explain the relative notion of risk. For instance, the U.S aggregate stock returns are characterized by sharper variations in return compared to the U.S short-run govern bond payoffs. Since the U.S bond returns vary, sometimes unexpectedly, it can easily refer to them as risky. But stock returns are riskier. But bonds are identified as riskless and stocks as risky to implement the economic analysis. This is a helpful approach because it helps place the assets into different groups until there is a specified approach to the assets.  

Notice also that there is a need to identify financial assets that are not bonded, don not guarantee, based on economic incentives, that there could be any payment(s). Practically, 'guarantee offered but legal precedents drive risky assets, government decrees social norms and such factors. They work as long as they have various extents of social value. However, they are not conferred by pure economic incentives. And since bonds do come with some 'guarantee' of payment (s), they qualify as arising from "non-economic reason."

Having discussed these important aspects of the financial accelerator models, we can look at the building blocks that make them.

Firm profit function

The first pillar is the dynamic profit function of a firm. When looking at this aspect, it is critical to take into consideration the time horizon. In other words, what is the time frame for setting this research in action? One can extend the analysis and results as far as they want.

Considering the two assets type we have mentioned above, where stock is risky, it can be placed in the model's first part. This is called the dynamic profit function. There are two important questions here: the first one seeks to answer the location of the short-term riskless bonds, and the second makes the distinction in reading the profit function, one between the optimization issues one small firm faces against the aggregate market variables. 

Financing constraint 

Financing constraints can be used in the accelerator framework as the most important conceptual idea. An analysis may revolve their approach around this idea, which makes its clarity very crucial. One of the most practical problems with firms is that to facilitate the purchase of physical assets (like machinery, equipment, and so on), they need enough market value of financial assets. This is the only way to facilitate the borrowing needed to purchase their order. Hence, the 'market' value characteristic of financial assets is very crucial. It becomes the indicator of both the price and quantity of the financial assets the firm holds. In this case, the model seeks to answer the question of why firms need to borrow. The financing constraint is the most probable cause. Note the crucial idea that a borrower cannot be forced to borrow more than what they want, but can be compelled to borrow less.

Government policy

Government regulations are key to the operation of financial markets. They are there to control how borrowers and lenders interact, which makes them a crucial building block for the financial accelerator model.

Profits and dividends

Publicly-traded companies pay dividends to their stakeholder. Different countries have varying dividend policies, which reflect different economic structures. It is considered when setting up the financial accelerator models.

Conclusion

Economic development and growth depend on major on how consumers and producers interact. And since the financial market is an important player in economies, finding ways to curb the effect of financial market failures can help save many economies. 

Author: James Hamilton