The implications of dynamic financial frictions for DSGE models

This paper shows that when financial frictions are modeled dynamically, broader inferences can be drawn from DSGE models. By embedding a partial equilibrium framework of bankruptcy proceedings in a dynamic New Keynesian model I find, for example, that financial liberalization episodes are only effective when the judicial system is efficient. More generally, I find that the model responses to various shocks depend on the duration of bankruptcy and the costs incurred during the bankruptcy process. State-level data supports one prediction of the model; U.S. monetary policy is most effective in states with longer foreclosure proceedings.