**5. Discussion and remark**

Through estimation of our model, we found three key findings during the period of the Great Recession and after it, which has already described in the previous section. Without hesitating duplication, we summarize these points.

First, as can be seen from **Figures 4** and **5**, the timing of the two different financial shocks modeling as balance sheet shocks in financial and nonfinancial firms have not arisen simultaneously, but the bank's balance sheet shock has sharply rose prior to the surge of the corporate balance sheet shock. When a financial crisis brings blooming degeneration of both balance sheet, this timing pattern (not concurrent, but sequential timing) must be noted as a lead of endogenous relationship of the balance sheet conditions in both banking sector and the corporate sector. Our model, however, has limitations. That is, we assume the two balance sheet shocks to be independent from each other and further do not allow the corporate sector to keep the bank's equity as an asset of his balance sheet. Thus, it may be inappropriate to interpret the endogenous relationship between the two net-worth shocks. Yet, it is worth noting about remark of the timing pattern of the two financial shocks during the Great Recession.

Second, we found that during the Great Recession, contributions of corporate balance sheet shock are relatively smaller in models with constant volatility shocks as Cases A and C than in models with SV shocks as Cases B and D as shown in **Figures 7–10**. This result suggests that estimation without the data-rich environment is likely to under-evaluate importance of the corporate balance sheet shock. Furthermore, an accuracy of estimating the corporate balance sheet shocks during

the Great Recession play an important role of accounting for the economic recovery of the U.S. economy. For instance, in cases with constant volatility shocks as Cases A and C, a slow recovery of output is mainly explained by the negative TFP shock. On the other hand, in cases with SV shocks as Cases B and D, it is mainly explained by a prolonged negative corporate balance sheet shock. The slow recovery of the U.S. economy after the Great Recession remains as an important question, and a persuasive description of this question requests a precise estimation of trace of these shocks. To this end, especially for estimating the corporate net worth shock, we hope that a data-rich approach with SV shocks must be more reliable than standard data structure.

of the macroeconomic fluctuations after the Great Recession, in contrast to a stan-

From a view of evaluating policies, the implementation of TARP has sufficiently worked to mitigate the bank's negative net-worth shocks und upturned the output and the investment. The model and empirical results in this study suggest that such a bail-out program must be workable effectively in case of a serious recession followed by a financial crisis with failures of financial institutions. On the other hand, the slow recovery of the U.S. economy after the Great Recession can be explained by the wounded balance sheet of the non-financial corporate sector,

The authors would like to especially appreciate Micheal Julliard (Bank of France) and Rafael Wouters (National Bank of Belgium) for their comments. And they also thank discussion with Gianni Amisano, Ryo Jinnai, Tatsuyoshi Okimoto, Tsutomu Miyagawa, Masaya Sakuragawa, Tasturo Senga, Etsuro Shioji, Hajime Tomura, Toshiaki Watanabe and other participants of the seminars at Gakusyuin Univ. and Osaka Univ. and at International Conference of Advanced Macroecononometrics 2013 held at Hitotsubashi Univ., 4th ESRI-CEPREMAP joint workshop 2013, 10th Biennial Pacific Rim Conference by Western Economic Association, 46th annual conference of Money Macro and Finance (MMF) 2014 at Univ. of Durham, the annual meeting of Canadian Economic Association 2014, and Autumn Meeting of Japan Society of Monetary Economics 2018, We also thank kindly comments from Yasuharu Iwata and Koichi Yano in the process of writing the study. Remaining

**No. Variables Proc. Observation explanation Unit of data Source**

1 **R** 6 Interest rate: Federal Funds Effective Rate % per annum FRB

3 **C1** 5\* Gross personal consumption expenditures Billion dollars BEA

5 *π***<sup>1</sup>** 8 Price deflator: Gross domestic product 2005Q1 = 100 BEA 6 **w1** 2 Real Wage (Smets and Wouters, 2007) 1992Q3 = 0 SW

7 **L1** 1 Hours Worked (Smets and Wouters, 2007) 1992Q3 = 0 SW

8 **RE1** 6 Moody's bond indices - corporate Baa % per annum Bloomberg

**<sup>1</sup>** 7 Commercial banks leverage ratio Total asset/net

ratio

issuer loans

**<sup>1</sup>** 3 Nonfarm non-fin. Corp. business leverage

11 **s1** 1 Charge-off rates for all banks credit and

Billion of chained 2000

worth ratio

Total asset/net worth ratio

% per annum FRB

Billion dollars BEA

BEA

(2007)

(2007)

FRB

FRB

export)

investment

dard DSGE model.

*Source of the Great Recession*

**Acknowledgements**

**Appendix**

9 **Lev<sup>F</sup>**

10 **Lev<sup>E</sup>**

**49**

which is not healed in a short period.

*DOI: http://dx.doi.org/10.5772/intechopen.90729*

errors should be regarded as those solely of the authors.

2 **Y1** 5 Real gross domestic product (excluding net

4 **I1** 5\* Gross private domestic investment - Fixed

**Case A and Case B: The standard Data Structure**

Third, there is another important finding from the historical decomposition which is the behavior of the bank's balance sheet shock. A sharp decline of the bank's balance sheet shock was obviously associated with the Great Recession, and rapid reductions of output and investment have stem from two net-worth shocks, as shown in **Figures 7** and **8**. Immediately after end of the Great Recession, the bank's balance sheet shock, however, quickly reversed its direction from negative to positive, and picked up both of output and investment upward. When we consider the timing of this reversal, it was plausible that the execution of the TARP is behind this counterturn. That is, TARP would have successfully made downward trend of the bank's balance sheet change upward. From our finding about the positive contribution of the bank's net-worth shock to the real GDP and investment right after the end of the Great Recession period, the executing TARP might be one of the major factors behind the stopping further degeneration of the recession and contributing to the recovery of the U.S. economy.

These three findings seem to support the Basel III framework developed by the Basel Committee in response to the global financial crisis of 2007–2009. The Basel III revised in order to strengthen the regulation, supervision and risk management of banks, by reducing excessive variability of risk-weighted assets (RWA) of banks. In particular, for preventing global financial crisis, it might be effective to restore credibility of the RWA by complementing the risk-weighted capital ratio with a finalized leverage ratio and a revised and robust capital floor, according to our empirical findings.

### **6. Conclusion**

This study is to identify what structural exogenous shocks contributed to the Great Recession and to analyze the mutual relationship among macroeconomic and financial endogenous variables in terms of a medium scale New Keynesian DSGE model with two net-worth shocks in both the financial and nonfinancial firms, using data rich approach with as many as 40 observations. And it is plausible to incorporate two different financial frictions to a standard DSGE model to analyze the recession, since there was a broad consensus that solvency and liquidity problems of the major financial institutions such as Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, Citi group, and AIG, which either failed, were acquired under duress, or were subject to government takeover, might be attributed causing the Great Recession itself.

We considered four alternative cases based on the number of observation variables (11 vs. 40 variables) and the specification of the volatilities of the structural shocks (constant volatility vs. time-varying-volatility). Comparing these four cases, we suggested the following two pieces of empirical evidence in the Great Recession; (1) the negative bank net worth shock gradually spread before the corporate net worth shock burst, and (2) the data-rich approach and the structural shocks with SV evaluated the contribution of the corporate net worth shock to a substantial portion

### *Source of the Great Recession DOI: http://dx.doi.org/10.5772/intechopen.90729*

of the macroeconomic fluctuations after the Great Recession, in contrast to a standard DSGE model.

From a view of evaluating policies, the implementation of TARP has sufficiently worked to mitigate the bank's negative net-worth shocks und upturned the output and the investment. The model and empirical results in this study suggest that such a bail-out program must be workable effectively in case of a serious recession followed by a financial crisis with failures of financial institutions. On the other hand, the slow recovery of the U.S. economy after the Great Recession can be explained by the wounded balance sheet of the non-financial corporate sector, which is not healed in a short period.
