Aggregate Demand in Financial Crises

The Global Financial Crisis was marked by a simultaneous collapse of output, consumption, and investment. Financial-crisis models, along the lines of He and Krishnamurthy (2013) and Brunnermeier and Sannikov (2014), fail to replicate this co-movement, as investment falls but consumption tends to rise. Extending these models to New Keynesian economies does not resolve the puzzle, because the Keynesian aggregate-demand channel amplifies investment more than consumption. The puzzle can be resolved by imposing financial frictions not only on investment but also on consumption decisions. This finding supports the view that household debt is central to the macroeconomic dynamics of financial crises.