Economic Report of the President

GDP growth. To buy new capital goods, firms rely on several sources offinancing. These include internal funds, such as retained earnings or capitalinfusions from firm owners, and external funds, such as the proceeds fromloans and the sales of stocks and bonds. The amount of internal funds is relatedto the firm’s cash flow. In response to a slowdown in sales, cash flow will likelydecline, reducing the amount of internal funds and therefore increasing theamount a firm needs to obtain from external finance. But lenders will be lesswilling to loan funds to firms with smaller cash flow, and the value of firms’collateral is also likely to have decreased, further reducing their ability to obtainloans. Hence firms might be forced to reduce their investment. This reductionin turn will lead to lower output, lower cash flow, and yet again lower investment—leadingto a further deceleration in output. The effect can work inreverse during economic expansions, with rising GDP making it easier forfirms to get financing for new investment projects. This theory provides apossible explanation for why changes in the amount of investment can have amultiplier impact on the broader economy.The “financial accelerator” effect is roughly proportional to the size of thedecline in GDP, since the change in cash flow and the value of collateralwould be expected to be roughly proportional to the decline in output. Thereis no consensus, however, about the magnitude of the accelerator effect. Onestudy assessing the response of investment by firms to a monetary policytightening, both with and without a financial accelerator, showed that thepresence of an accelerator can cause the decline in investment to doublecompared to a situation in which there is no accelerator effect. Another studynoted that small firms, which are likely to be more limited in their ability toborrow than large firms, show much larger declines in inventory and salesgrowth during recessions than do large firms. This finding further suggests animportant role for the financial accelerator.The accelerator theory can also provide a link between asset price bubblesand recessions and expansions. When the prices of equities or real estate rise,the resulting increases in asset values raise the value of collateral, making iteasier for firms to obtain financing for investment—thus further raisingoutput growth. Conversely, declines in asset values from the bursting of assetprice bubbles can discourage investment.Although the financial accelerator theory helps explain why on average thedepth of the recession corresponds to the initial strength of the expansion, thetheory will not explain the behavior of all recessions and expansions.Investment is affected by things other than output growth, and, as will bediscussed more fully later in the chapter, economic shocks can affect othercomponents of GDP. In the most recent recession, for example, investmentfell more rapidly than in the average recession, but the fall in output was notparticularly large. The solid growth in consumption, boosted by expansionarymonetary and fiscal policy, helped reduce the fall in output.60 | Economic Report of the President