The financial crisis has brought into focus the importance of financial markets to a properly functioning economy. These markets help the economy allocate resources and shape the investment and saving decisions of the society.
While financial markets are essential to economic growth, they may also play a role in propagating the business cycle. Economists call this effect the "financial accelerator," meaning that conditions in financial markets can perpetuate and amplify shocks to economic activity. One important channel through which the financial accelerator operates is the way investment is affected by the external finance premium. The external finance premium is the difference between the cost of external funds and the opportunity cost of internal funds. Borrowing from lenders is almost always more expensive for a firm than using its own funds because lenders must be compensated for the costs of evaluating and monitoring borrowers. Therefore, the external finance premium is generally positive. Moreover, it is inversely related to the strength of a firm's balance sheet. Improvements in balance sheet strength will lower the premium, degradations will raise it. Changes in the premium affect the investment decisions of firms, which in turn affect real economic activity. It is because the value of a firm's assets and the overall health of its balance sheet generally move positively with overall economic activity that financial market conditions can amplify the effect of shocks to economic activity.
Measures of this external finance premium may contain valuable information about future economic activity. Corporate bond spreads, in particular the high-yield spread--the spread between the yields of high-yield (or junk) bonds and higher-grade bonds (say, AAA corporate bonds)--might be a suitable measure for this premium. The yields of the former type of bond are especially sensitive to the default probabilities of firms; thus, these yields are likely to be a good predictor of future economic activity. …