The magnitude and Cyclical Behavior of Financial Market Frictions

measures of expected default risk. Using non-linear least squares, we estimate the
structural parameters of the contracting problem between lender and entrepreneur of
the benchmark financial accelerator model of Bernanke, Gertler, and Gilchrist (1999)
(BGG hereafter).

We obtain precise time-specific estimates of the bankruptcy cost parameter, which
enable us to clearly reject the null hypothesis of frictionless financial markets. Fur-
thermore, for the expansionary period through mid-2000 our estimates are quite sim-
ilar to the calibrated values used in previous research. We also find that the degree
of financial market frictions exhibits strong cyclicality. The parameter estimate of
bankruptcy costs, in fact, increases by a factor of two during the latest economic
downturn before returning to pre-recession levels in early 2003. Finally, we show that
the model-implied (unobservable) external finance premium was close to zero until
the end of 1999 but rose sharply afterwards, providing an important explanation for
the sharp drop in capital spending during the latest economic contraction.

The remainder of the paper is organized as follows. Section 2 specifies the microe-
conomic debt-contracting framework and examines its comparative statics. Section 3
provides an overview of the data, while Section 4 describes the estimation methodol-
ogy. Section 5 presents the empirical results, and Section 6 concludes.

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