What is a Financial Accelerator?

A financial accelerator is a means by which developments in financial markets amplify the effects of changes in the economy. Conditions in financial markets and the economy may reinforce each other resulting in a feedback loop that produces a boom or bust despite the changes themselves being relatively small when examined individually. The idea is attributed to Federal Reserve Board Chairman Ben Bernanke and economists Mark Gertler and Simon Gilchrist.

Understanding Financial Accelerators

A financial accelerator often comes out of the credit market and eventually works through to impact the economy as a whole. Financial accelerators can initiate and amplify both positive and negative shocks on a macroeconomic scale. The financial accelerator model was proposed to help explain why relatively small changes to monetary policy or credit conditions could trigger large shocks through an economy. For example, why does a relatively small change in the prime rate cause companies and consumers to slash spending even though it is a small incremental cost?

The financial accelerator theory proposes that, at the peaks of business cycles, the majority of businesses and consumers have overextended themselves to varying degrees. This means that they have taken on cheap debt to finance improvements or expansion to their businesses and lifestyles. This also means that they are extra sensitive to any changes in the credit environment, more so than they would be at other points in the business cycle. When the expansion portion of the business cycle comes to an end, this same overextended majority gets pinched by poorer economy and tightening credit.

The Financial Accelerator and the Great Recession

The idea of credit conditions influencing the economy is not a new one, but the Bernanke, Gertler and Gilchrist model provided a better tool for guiding policy to take credit market impacts into effect. Even then, the financial accelerator model received very little attention until 2008, when Bernanke was at the helm of the Federal Reserve during a financial crisis that turned into the Great Recession. The financial accelerator model received a lot of attention as it provided a context for explaining the actions that the Fed was taking to minimize feedback loops or shorten their run time.

This is one of the reasons why so many of the bailout measures, as they became known, were focused on stabilizing the credit markets directly through the banks. In the financial accelerator model, slowed credit causes a flight to quality. This means that weaker firms and consumers are abandoned and credit is offered only to stronger firms. However, as more of these firms struggle with less consumer driven buying, they also fall out of favor. This loop continues until much of the credit is squeezed out of the economy, resulting in a lot of economic pain. Bernanke used his knowledge of financial accelerators to try and limit the pain and shorten the amount of time that the U.S. economy suffered with tight credit conditions.