Collaterals and macroeconomic volatility

In this paper, we study the effects of collaterals on business cycles and growth in monetary economies with credit market imperfections. We consider an endogenous growth model with a partial cash-in-advance constraint. It is assumed that the share of consumption purchases paid on credit depends positively on the collaterals available to the agent. In this case, money is no longer superneutral. We find that, under mild inflation rates, a higher money growth rate is welfare-improving and, surprisingly, it makes the occurrence of expectations-driven fluctuations less likely. The shape of credit share in consumption purchases, as outcome of regulatory policies, has an impact on both welfare and stability. In particular, the higher the sensitivity of the credit share to collaterals, the more stable the economy under rational expectations. These analytical findings are complemented by economic interpretations.     

International financial remoteness and macroeconomic volatility

This paper shows that proximity to major international financial centers seems to reduce business cycle volatility. In particular, we show that countries that are farther from major locations of international financial activity systematically experience more volatile growth rates in both output and consumption, even after accounting for political institutions, trade, and other controls. Our results are relatively robust in the sense that more financially remote countries are more volatile, though the results are not always statistically significant. The comparative strength of this finding is in contrast to the more ambiguous evidence found in the literature.     

Financial frictions and stabilization policies

After the financial crisis of 2007, in many economies, public and private debt have moved in opposite directions, as opposed to pre-2007 evidence. Private deleverage and public debt build-up may affect the recovery path of countries after a recession. In a new Keynesian model with financial frictions, we show that when the economy is hit by a credit risk shock, the negative correlation arising between public and private debt amplifies the response of GDP. In our setup, the traditional monetary-fiscal policy mix is not enough to offset this private-public debt mechanism and therefore bring back economic stability. When macroprudential policy is part of the policy mix, the private-public debt channel can be broken. Interestingly, depending on the macroprudential instrument, a trade-off may arise between private debt and output stabilization.     

Financial frictions and the futures pricing puzzle

In perfect capital markets, the futures price of an asset should be an unbiased forecast of its realized spot price when the contract matures. In reality, futures prices are often higher for some assets and lower for others. However, there is no stability in the relationship between futures prices and the realized spot prices. This instability has been a puzzle in the existing financial literature. The key to this puzzle may lie in the nature of the model and the lack of market imperfections. In this study, we take a theoretical approach in a dynamic multi-period environment. We incorporate competition between disparate economic agents and impose financial frictions (i.e., imperfections) that are in the form of hedging and borrowing limits on them. Our model gives rise to multiple equilibria, each with unique market clearing prices, with the market switching between these equilibria. Our analysis incorporates a comprehensive consideration of the risks faced by the futures markets participants (i.e., speculators and hedgers) and leads to a better understanding of the puzzle.     

Mandatory spending,political polarization,and macroeconomic volatility

This paper studies the impact of political polarization on macroeconomic volatility in a political economy model of optimal fiscal policy. I introduce the distinction between mandatory and discretionary public spending in a model where consumers disagree on the size of the public sector. In the presence of political turnover and political polarization, public policies that affect individual decision-making lead to macroeconomic volatility. I show that the legislative requirements behind the changes in mandatory public spending can reduce macroeconomic volatility caused by political polarization and political turnover. The numerical simulations of the model suggest that in the presence of a binding constraint on the changes in mandatory spending, an increase in the political polarization is associated with an increase in the share of mandatory spending and a decrease in the macroeconomic volatility, consistent with the U.S. data.     

Interest rate volatility and macroeconomic dynamics: Heterogeneity matters

We examine the relation between real interest rate volatility and aggregate fluctuations for a diverse sample of countries. Compiling a new dataset including emerging and advanced countries, the substantial variation in our data yields novel results: (a) stochastic volatility outperforms Markov‐switching in representing interest rates, (b) some advanced economies can be more volatile than emerging markets, and (c) creditors take on more debt following volatility shocks. We show how an equilibrium business cycle model with uncertainty shocks can generate these facts. Sample heterogeneity produces significant parameter differences, playing an important role in distinguishing the effects of volatility shocks.     

Foreign currency debt, risk premia and macroeconomic volatility

This paper studies the relationships between foreign currency debt, macroeconomic volatility, and risk premia in a model of a small open emerging market economy. The external value of the local currency is counter-cyclical, so that foreign currency debt requires larger repayments than local currency debt in bad states of nature. The level of foreign currency-denominated debts, therefore, affects the volatility of aggregate demand and by extension of the exchange rate. Exchange rate volatility is in turn an important determinant of the risk premium on local currency debt. Finally, this risk premium is a major factor in the choice of local versus foreign currency for emerging market borrowers. The mutual endogeneity of foreign currency debt, risk premia, and macroeconomic volatility creates important feedback effects in the economy: small increases in international risk aversion may entail large amplification effects on macroeconomic volatility since domestic borrowers substitute towards cheaper but riskier foreign currency debt finance.     

Financial frictions and the ratio in UK manufacturing

This note concerns an asymptotic distribution result from the literature on nonlinear estimation with integrated variables. It points out a way of strengthening local asymptotic distribution results towards results that hold for the global minimizer of the criterion function.     

Financial frictions and investment: requiem in Q

Understanding the nature of financial frictions faced by firms is relevant for both monetary and fiscal policy experiments. Empirical investment studies commonly find that proxies for firms' internal funds are significant as explanatory variables, particularly in the Q-theory based regression framework. These findings are often interpreted as evidence of financial frictions. This paper investigates that inference by specifying and estimating a class of dynamic optimization models where imperfectly competitive firms face financial constraints. Market power induces the principal link between investment and internal funds. We find no evidence to support the argument that capital market imperfections contribute to the relationship between investment and profitability.     

The link between institutions, technical change and macroeconomic volatility

This paper evaluates the role of technical change as a mediating channel through which the effects of institutions trickle down to affect growth volatility. Using different samples, estimation procedures and indicators of institutions and technical change, the results show that technical change is an important stabilizing force of growth volatility and that at least part of the stabilizing force of technical change originates from strong institutions. This conclusion does not appear to be generated by weak data, simultaneity bias or measurement errors and is remarkably robust to a large number of alternative specifications.     

Wealth inequality, preference heterogeneity and macroeconomic volatility in two-sector economies

We explore the link between wealth inequality, preference heterogeneity and macroeconomic volatility in a two-sector neoclassical growth model. First we prove that, if agents have homogeneous preferences, when the absolute risk tolerance is a strictly convex (concave) function, sufficiently high (low) levels of wealth inequality may lead to endogenous fluctuations in the neighborhood of the steady state. Second, we consider the effects of preference heterogeneity when agents are homogeneous with respect to their wealth. We show that when the utility function belongs to the HARA class, sufficiently high levels of preference heterogeneity may lead to endogenous fluctuations in the neighborhood of the steady state if the elasticity of intertemporal substitution in consumption is greater than one.     

Financial structure on growth and volatility

By applying the pooled mean group estimator to a large panel up to 40 countries over the 1960–2009 period, this study finds that financial structure is significantly cointegrated to both economic growth and its volatility. In particular, the relationship is positive in nature, suggesting that more market-based countries enjoy faster economic growth but suffer more from economic fluctuations in the long run. Accordingly, in sharp contrast to the existing evidences, we conclude that the architecture of an economy's financial system matters for real sector performance. Moreover, the findings are robust to a variety of sensitivity checks, including the problem of endogeneity, the use of different financial structure (and growth volatility) indicators, the inclusion of extra growth (volatility) determinants, and the control of cross-sectional dependence in the panel data.     

Financial frictions and optimal stabilization policy in a monetary union

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.     

Financial market frictions in a model of the Euro area

We build a model of the euro area incorporating financial market frictions at the level of firms and households. Entrepreneurs borrow from financial intermediaries in order to purchase business capital, in the spirit of the “financial accelerator” literature. We also introduce two types of households that differ in their degree of time preference. All households have preferences for housing services. The impatient households are faced with a collateral constraint that is a function of the value of their housing stock. Our aim is to provide a unified framework for policy analysis that emphasises financial market frictions alongside the more traditional model channels. The model is estimated by Bayesian methods using euro area aggregate data and model properties are illustrated with simulation and conditional variance and historical shock decomposition.     

Financial frictions,interest rate dynamics,and international business cycle synchronization

A two‐country real business cycle model with national endogenous borrowing constraints and working capital requirements can account for the high level of international co‐movements. The effects of technology shocks are transmitted internationally through the dynamics of the interest rate. Specifically, the borrowing mechanism brings about a wedge between the real interest rate and the expected marginal product of capital, such that interest rates fall following positive technology shocks. A lower interest rate induces more investment by Foreign firms, which in turn contribute to greater synchronization of economic activities across countries. Moreover, terms of trade amplify the effects of technology shocks.     

Financial leverage and market volatility with diverse beliefs

We study a general equilibrium model of asset trading with financial leverage, where the investors can engage in speculative trading with diverse beliefs about the asset??s fundamental value. We show that an increase in the leverage ratio causes the stock price to rise in the current period through a ??leverage effect??, and will result in more borrowing and more stock purchase that pumps the stock price higher in the subsequent period, known as the ??pyramiding effect??. There can also be a ??depyramiding effect?? when the price falls because lenders issue margin calls and force stock sales, contributing to further stock price plummeting. Price changes from depyramiding effect, however, may not take effect when margin calls are not triggered. We demonstrate that, under certain conditions, decreasing leverage ratios leads to lower stock price volatility, measured by the variation of prices caused by an exogenous shock, when the shock is unanticipated. The influences of dispersion of beliefs and available investment funds on the relation between financial leverage and market volatility are also examined. When the shock is anticipated, we demonstrate that reducing leverage ratios may not lower stock price volatility, which poses an important challenge to future studies on this issue.     

Estimating general equilibrium models with stochastic volatility and changing parameters

This paper explores the importance of specification in estimated general equilibrium models with changing monetary policy parameters and stochastic volatility. Simulated data is used to estimate models with incorrectly specified exogenous shocks (time-varying vs. constant variance) and models misspecifying the way Taylor rule parameters change over time (constant vs. drifting vs. regime-switching). The model correctly identifies some changes in monetary policy parameters, even when misspecified. The inclusion of stochastic volatility greatly improves model fit even when the data is generated using constant variance exogenous shocks; this relationship is stronger in data generated from models with changing policy parameters.     

Financial market integration, labor markets, and macroeconomic policies

We used a dynamic two-country optimizing model featuring a labor–market friction to analyze the implications of financial market integration for the propagation of macroeconomic policies in an open economy. Our main result is that the labor–market friction we analyzed substantially reduces the magnitude of the effect of financial market integration on the propagation of macroeconomic policies.     

Financial frictions and total factor productivity: Accounting for the real effects of financial crises

Financial crises in emerging economies are accompanied by a large fall in total factor productivity. We explore the role of financial frictions in exacerbating the misallocation of resources and explaining this drop in TFP. We build a two-sector model of a small open economy with a working capital constraint on the purchase of intermediate goods. The model is calibrated to Mexico before the 1995 crisis and subjected to an unexpected shock to interest rates. The financial friction generates an endogenous fall in TFP and output and can explain more than half of the fall in TFP and 74 percent of the fall in GDP per worker.