The link between the real economy and financial markets stems from firms’ need for external finance to engage in physical investment opportunities.
Decreased economic activity further cuts the asset prices down, which leads to a feedback cycle of falling asset prices, deteriorating balance sheets, tightening financing conditions and declining economic activity.
They argue that financial accelerator results from changes in credit market conditions, which affect the intrinsic costs of borrowing and lending associated with asymmetric information.
[9][10][11] As a well-known example of the traditional view of acceleration, Samuelson (1939) argues that an increase in demand, for instance in government spending, leads to an increase in national income, which in turn drives consumption and investment, accelerating the economic activity.
[12] As a result, national income further increases, multiplying the initial effect of the stimulus through generating a virtuous cycle this time.
[13] In his seminal work on debt and deflation, which tries to explain the underpinnings of the Great Depression, he studies a mechanism of a downward spiral in the economy induced by over-indebtedness and reinforced by a cycle of debt liquidation, assets and goods’ price deflation, net worth deterioration and economic contraction.
[citation needed] Recently, with the rising view that financial market conditions are of high importance in driving the business cycles, the financial accelerator framework has revived again linking credit market imperfections to recessions as a source of a propagation mechanism.
Many economists believe today that the financial accelerator framework describes well many of the financial-macroeconomic linkages underpinning the dynamics of The Great Depression and the subprime mortgage crisis.
One way is focusing on principal–agent problems in credit markets, as adopted by the influential works of Bernanke, Gertler and Gilchrist (1996),[7] or Kiyotaki and Moore (1997).
Principals cannot access the information on investment opportunities (project returns), characteristics (creditworthiness) or actions (risk taking behavior) of the agents costlessly.
These agency costs characterize three conditions that give rise to a financial accelerator: Thus, to the extent that net worth is affected by a negative (positive) shock, the effect of the initial shock is amplified due to decreased (increased) investment and production activities as a result of the credit crunch (boom).