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The financial accelerator amplifies shocks through credit markets: when net worth falls, borrowers appear riskier, widening credit spreads. Higher borrowing costs reduce investment and entrepreneurship, worsening the initial shock. Asset price declines feed back to reduce net worth, creating a negative feedback loop.
From your study of information asymmetry, you know that lenders cannot perfectly observe borrowers' actions or project quality, creating a fundamental wedge between the cost of internal and external funds. The financial accelerator is the mechanism by which this wedge amplifies and propagates economic shocks, turning what might be a mild downturn into a deep recession. The concept, developed primarily by Bernanke, Gertler, and Gilchrist, explains why financial markets do not merely reflect real economic conditions but actively worsen them.
The starting point is the external finance premium — the extra cost a borrower pays over the risk-free rate to compensate lenders for the information problems inherent in lending. This premium depends critically on the borrower's net worth: the value of assets minus liabilities. When a firm or household has substantial net worth, they can post collateral and have more "skin in the game," reducing the lender's exposure to default. The external finance premium falls, and credit flows freely. But when net worth declines — because asset prices drop, profits fall, or debts increase — lenders face greater risk and charge higher spreads. Credit tightens precisely when borrowers need it most.
The amplification arises from the feedback loop between asset prices, net worth, and borrowing conditions. Consider a negative productivity shock that reduces profits and lowers the value of firms' assets. Lower asset values reduce net worth, which raises the external finance premium, which increases the cost of investment. Reduced investment further depresses economic activity and asset prices, which further erodes net worth. Each round of the cycle amplifies the original shock. This is why the mechanism is called an "accelerator" — it does not create shocks, but it makes them larger and more persistent than they would be in a frictionless economy. A 1% decline in productivity might produce a 3% decline in investment once the financial accelerator is operating.
The mechanism also works in reverse during booms: rising asset prices increase net worth, lower credit spreads, stimulate borrowing and investment, and drive asset prices higher still. This symmetry means the financial accelerator amplifies both expansions and contractions, contributing to boom-bust cycles. The 2008 financial crisis was a dramatic illustration: falling house prices destroyed household and bank balance sheets, credit spreads skyrocketed, lending froze, and the resulting collapse in spending fed back into further asset price declines. Understanding this mechanism is essential for designing macroprudential policy — regulations that aim to prevent excessive leverage buildup during booms so that the accelerator has less fuel when the inevitable downturn arrives.