Understanding Financial and Non-Financial Balance Sheet Recessions

Advisor: Fernando Mendo

Co-advisor: Carlos Viana de Carvalho

This paper examines the dynamics underlying financial and non-financial balance sheet recessions.We develop a continuous-time model with three agents that captures the distinct mechanisms associated with each type of downturn. Our analysis shows that the effects of capital shocks to firms’ balance sheets depend on the capitalization of financial intermediaries. When intermediaries are well capitalized, such shocks trigger fire sales of capital and heightened volatility, leading to severe downturns through the balance sheet channel. By contrast, when intermediaries are poorly capitalized, the same shocks generate deeper contractions in investment and output, as constrained banks reduce credit supply through the lending channel. These results are consistent with some empirical facts and underscores the role of intermediary capitalization in shaping macro-financial outcomes.