FINANCIAL MARKET IMPERFECTIONS AND BUSINESS CYCLES

Because of financial market imperfections, such as those generated by asymmetric information in financial markets, which lead to breakdowns in markets, like that for equity, in which risks are shared, firms act in a risk-averse manner. The resulting macroeconomic model accounts for many widely observed aspects of actual business cycles: (a) cyclical movements in real product wages, (b) cyclical patterns of output and investment including inventories, (c) sensitivity of the economy to small perturbations, and (d) persistence. More downward flexibility in wages and prices may exacerbate the plight of an economy that is in a deep recession.