Financial Frictions, Financial Shocks, and Aggregate Volatility

The Great Moderation was accompanied by an increase in financial volatility. We explore the sources of these divergent patterns in volatilities by estimating a model with time-varying financial rigidities subject to structural breaks in the size of shocks, the monetary policy rule coefficients, and the average size of the financial rigidity. Institutional changes are key in accounting for the Great Moderation and in shaping the transmission mechanism of financial shocks. The increase in financial volatilities is accounted for by larger financial shocks, but the vulnerability of the economy to these shocks is significantly alleviated by the estimated changes in institutions.