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Financial frictions and shock transmission: the Portuguese case

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This article uses the PESSOA model to assess the macroeconomic impact of two relevant shocks that conditioned the Portuguese economy in the recent past: the fall in external demand and the rise in sovereign debt risk premium. PESSOA is a general equilibrium model, calibrated to incorporate the main features of the Portuguese economy. The recession driven by the external demand shock is magnified by the prevalence of financial frictions, in particular due to the drop in investment, which does not occur in the case of the risk premium shock. Financial frictions increase the persistence of recessionary effects, especially in the external demand shock, to the extent that capital holders experience a persistent reduction of their net worth, which increases the degree of leverage, the risk levels associated with investment projects, and the costs of external financing. Results show also that the recession causes a decrease in fiscal revenues in both shocks, and thus fiscal policy must take a restrictive stance to ensure the stability of public debt in the medium and long term.
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Journal (repec) 
Economic Bulletin