The cyclicality of the finance premium over the business cycle

This paper examines the main determinants of the cyclicality of the finance premium in the cost channel framework, which has received less attention in the literature. We decompose the finance premium into a cost effect and a leverage effect. We show that in both the cost channel model and the credit channel model (Bernanke, Gertler and Gilchrist 1999), the cyclicality of the finance premium is determined mainly by the size and sign of the leverage effect . Some key factors that determine the leverage effect are, the nature of shocks, the degree of loan persistence in relation to output or net worth, and the stance of monetary policy . • We examine the cyclicality of the finance premium (FP) in two financial frictions frameworks. • Bernanke et al. (1999),Bernanke, B., Gertler, M. and Gilchrist, S. (1999). ‘The Financial Accelerator in a Quantitative Business Cycle Framework’, Handbook of macroeconomics. • We introduce a cost channel model that incorporates endogenous risk. • We decompose the FP in the cost channel, into a cost effect and a leverage effect. • In both frameworks it is the leverage effect that determines the cyclicality of the FM. • 3 key factors that affect the size and direction of the leverage effect: (i) the nature of shocks, (ii) the dynamics and persistence of loans and (iii) monetary policy .