Impact of Credit Markets on Dynamic Stochastic Real Aggregate Production

Abstract

This paper provides a dynamic stochastic macro-financial model that describes the impact of the credit market on real production risk and provides some empirical evidence of the reasonableness of the model. Our model shows that the uncertain real sector output affects the performance of the credit market, which in turn, impacts the real production of an economy, resulting in a positive feedback effect. Our model shows that an increase in financial sector leverage and household sector leverage would induce a stronger feedback effect and increasing marginal production of financial leverage. Our model identifies the key risk drivers in measuring the performance of an economy that can be used to attribute quarterly GDP growth rate over the sample period 2000 Q1 to 2013 Q3. The empirical results can be used to interpret the underlying causes of economic boom-bust cycles and provide insights into a sustainable GDP growth pattern. This macro-finance model has many applications. For example, the risk drivers of the GDP growth rates can be used to study equity broad-based market returns (Ho and Lee (2014a)).The model can also be used to specify a structural macro-finance model that can be used to evaluate efficacy of some financial regulations (Ho and Lee (2014b)).