The real effects of financial disruptions in a monetary economy

Abstract

A large literature in macroeconomics concludes that disruptions in financial markets have large negative effects on output and (un)employment. Though diverse, most papers in this literature share a common characteristic: they employ frameworks where money is not explicitly modeled. This paper argues that the omission of money may hinder a model’s ability to evaluate the real effects of financial shocks, since it deprives agents of a payment instrument that they could have used to cope with the resulting liquidity disruption. In a carefully calibrated New-Monetarist model with frictional labor, product, and financial markets, we show that the existence of money dampens or even nearly eliminates the real impact of financial shocks, depending on the nature of the shock. We also show that the propagation of financial shocks to the real economy depends on the inflation level: high inflation levels magnify the real effects of adverse financial shocks.