Evaluating international financial integration under leverage constraints

The global financial crisis has undermined many economists' views about the benefits of open financial markets. Anecdotal evidence seems to indicate that financial linkages may propagate shocks during crises. This paper develops a simple two-country model in which financial liberalisation across countries takes place in the presence of credit market distortions within countries. Countries may be subject to macro risk coming from productivity shocks and direct shocks to the credit system (‘financial shocks’). Three different degrees of financial linkages between countries are examined. It is shown that the type of financial integration is critical for both macroeconomic outcomes and welfare. In particular, financial integration in bond markets alone may increase aggregate consumption volatility and reduce welfare. Financial integration in both bond and equity markets generates high positive co-movement across countries, but is welfare-improving.     

Energy price shocks and milk price adjustments

Much previous research on energy price transmission sheds light on the relationship between oil prices and aggregate commodity prices, such as for agricultural products, or food price indexes. This letter uses data from 12 U.S. cities between 2001 and 2011 to examine how energy prices are transmitted to fluid milk products at the retail level. Results indicate the existence of an asymmetric energy pass-through (a rise is transmitted faster than a fall in prices) and that private label milk products are more insulated from energy price shocks and adjust at similar rate with national manufacturer brands.     

Fiscal adjustments and asset price changes

This paper examines the links between asset price movements and fiscal adjustments. Our findings suggest that higher asset prices improve fiscal balances and contribute to sustained consolidation. This refers in particular to real equity and real residential property prices. We find evidence that revenue windfalls due to higher residential, commercial property and equity prices can be sustained, thus, improving revenue and primary balances. There is evidence of a positive association of some asset prices changes with expenditure adjustments. Fiscal adjustments and in particular sharp spending cuts are more likely to be successful if undertaken in periods of dire budgetary and economic conditions.     

Upstream vertical integration with automatic price adjustments

Regulators often must decide whether they should allow a utility to vertically integrate. The relevant policy concerns are whether vertical integration might allow the utility to increase its downstream price and what, if any, additional constraints must be placed on the utility to prevent potential price increases. The extant literature provides regulators little guidance, and this paper fills the void by providing an analysis of the effects of upstream vertical integration by a regulated firm. The paper considers integration into the production of an intermediate input for which the price is automatically passed through to downstream customers. It demonstrates that vertical integration can result in higher downstream prices and greater profit for the utility whenever regulators imperfectly monitor input prices.     

Size and sign asymmetries in house price adjustments

Long-run mean-reversion in real house prices is determined by the relative strength of fundamental factors against the short-run influences. This article suggests that the adjustment towards the long-run trend in house prices could display non-linear behaviour due to some intrinsic characteristics of the housing market. Accordingly, sign and size asymmetries as well as possible structural breaks are taken into account in a unit root testing exercise for twenty-nine countries. Our results suggest that mean-reversion exists for seventy percent of the countries in our sample. Moreover, the out-of-sample forecasting performance of our non-linear models in predicting house prices is better than a simple auto-regressive benchmark for some countries.     

Multicomponent signals and financial constraints

ABSTRACT

The inventive process creates knowledge asymmetries between research-intensive firms and external investors, making it difficult for firms to obtain funding for inventive activities. Consequently, most research-intensive firms face financial constraints (FC). Some suggest patents act as signals to reduce asymmetries, attracting external financing. Yet, prior findings are mixed. We integrate literature on FC with signaling to explore these inconsistent conclusions. We argue ambiguity in previous studies results from examining patents as sending a single signal. We examine impacts of three firm-level attributes on FC – use of emergent technology inputs, firm age, and repeat alliance partners. We demonstrate consideration of multiple simultaneous signals provides better insights into the patenting-FC relationship.     

Excess price volatility and financial innovation

Summary. In a three-period finite exchange economy with incomplete financial markets and retrading, we study the effects of the degree of incompleteness and of changes in the financial structure on asset price volatility. In what are essentially no aggregate risk economies, asset price volatility is a sunspot-like phenomenon. If markets are completed by financial innovation, asset price volatility reduction is generic. With aggregate risk, changes in the financial structure affect asset price volatility through a pecuniary externality. Financial innovation which decreases equilibrium price volatility can be crafted under conditions of sufficient market incompleteness. Numerical examples illustrate the role of risk aversion for volatility changes and show that, with or without aggregate risk, reducing the degree of incompleteness per se is not necessarily associated with a volatility reduction.Received: 10 October 2003, Revised: 3 June 2004, JEL Classification Numbers: C60, D52, G10. Correspondence to: Alessandro CitannaThis research project stems from and expands previous work circulated as Financial innovation and price volatility, GSIA Working Paper #1996-E30 and Controlling price volatility through financial innovation, Kellogg Working Paper #2002-1338. We thank Herakles Polemarchakis and Chris Telmer for their comments. We are grateful to an anonymous referee for careful reviews of earlier versions. The first author thanks also GSIA - Carnegie Mellon University for the kind hospitality during Fall 2002, when part of this project was completed.     

Modelling price pressure in financial markets

We present experimental evidence that, unlike traditional assumptions in economic theory, security prices do not respond to pressure from their own excess demand. Instead, prices respond to excess demand of all securities, despite the absence of a direct link between markets. We propose a model of price pressure that explains these findings. In our model, agents set order prices that reflect the marginal valuation of desired future holdings, called “aspiration levels.”In the short run, as agents encounter difficulties executing their orders, they scale back their aspiration levels. Marginal valuations, order prices, and hence, transaction prices change correspondingly. The resulting price adjustment process coincides with the Global Newton Method. The assumptions of the model as well as its empirical implications are fully borne out by the data. Our model thus provides an economic foundation for why markets appear to search for equilibrium according to Newton’s procedure.     

Price expectations,disequilibrium adjustments,and macroeconomic price stability

This paper examines the possibility of extending the basic theorems of the risk-free, two-sector, two-factor, constant returns to scale model of production to cover situations with price uncertainty. It is shown that the Rybczynski and Stolper-Samuelson theorems may fail to hold for certain cases while the factor price equalization theorem cannot carry over to the stochastic world, provided firms in the uncertainty sector exhibit decreasing absolute risk aversion. The implications of uniform (relative) changes in both factor endowments and in both (expected) commodity prices are also explored.     

Asymmetries in price and quantity adjustments by the competitive firm

Focusing on the crucial role of inventory carry-overs in the production and sales decision, we describe the profit maximizing behavior of a dynamic competitive firm facing random prices. Each firm's behavior is incorporated into a stochastic equilibrium model of the competitive industry with uncertain demand. The industry model exhibits asymmetric cyclical fluctuations of the “Keynesian” sort: when demand is weak, output contracts while price holds at a fixed floor; when demand is strong, price increases as output is constrained by a ceiling. Even in a pure world of constant returns, without increasing costs, the inability to instantaneously coordinate production and sales along with the existence of inventories is sufficient to yield a “backward L” shaped supply curve for the short run.     

Exchange rate and price level dynamics under perfect substitutability of real and financial assets

This note investigates the implications of arbitrage between domestic financial and real assets for the evolution through time of the exchange rate and the price level after a monetary schock. The model yields results contrasting sharply with those of the traditional model of exchange rate dynamics based on international arbitrage [e.g. Dornbusch (1976)]. In particular, there is no overshooting of the exchange rate and the short-run deviations from purchasing power parity are the opposite of those implied by the traditional model.     

Asymmetric capacity constraints and equilibrium price dispersion

Price dispersion arises despite perfect information about prices. In equilibrium the higher capacity firm adopts a high-price, high-availability strategy, the lower capacity firm adopts a low-price, low-availability strategy, and consumers are more likely to shop at the high-price firm.     

Industrial districts and financial constraints to innovation

Informational frictions between borrowers and lenders are particularly acute for innovative firms undertaking high‐risk projects. As a consequence, banks may end up denying credit to them. However, the literature on relationship finance predicts that a closer relationship between credit suppliers and obligors is deemed to alleviate information asymmetries, hence preventing credit rationing from occurring. The question of whether such situations also apply to innovative firms has so far remained relatively unexplored. Using a cross‐section of Italian manufacturing firms, I find that credit constraints appear to be more severe for firms undertaking innovative activities, although such effects are weaker when measures of R&D intensity are included. The empirical analysis also shows that firms located in an industrial district have easier access to external finance. If I move to consider firms engaged in substantial R&D activities located in a district, results suggest that they can benefit from better financial conditions.     

Investment and financial constraints in Hungarian agriculture

We investigate credit market imperfections in Hungarian agriculture. Farmers with low debts and using mainly rented land are liquidity constrained. We find also evidence for the presence of soft budget constraint for high debt and corporate farms.     

Non-linear adjustments on the excess sensitivity of consumption with liquidity constraints

This article investigates the role of domestic credit markets in explaining the excess sensitivity of private consumption to disposable income using heterogeneous panel data of 19 OECD countries over the last two decades. We find that the degree of the excess sensitivity has decreased as the liquidity constraints of households have been alleviated: the estimated time-varying coefficients for the marginal propensity to consume vary between 0.16 for the countries with low liquidity constraints and 0.38 for those with high liquidity constraints. We also provide evidence that the excess sensitivity has been more prominent after the global financial crisis in some advanced countries, such as Japan, Spain, and the United States, where sharp deleveraging of households has been ongoing.     

Aggregate fluctuations, financial constraints and risk sharing

Summary. Private information and costly state verification often result in credit rationing in models with smooth investment, affecting both loan size and total investment. The optimal contract is derived in a dynamic stochastic growth model with capital for two types of models: one with symmetric information and the other with asymmetric information and costly state verification. When all information is observed costlessly, the equilibrium optimal contract provides complete insurance to risk-averse savers against aggregate fluctuations. When information is asymmetric and there is costly state verification, the equilibrium optimal contract provides only partial insurance against aggregate shocks. The extent of insurance is measured by the marginal rate of transformation of consumption between borrowers and lenders which is closely linked to the user cost of capital. The deadweight monitoring costs create a wedge between a borrower's cost of capital and a lender's stochastic discount factor, with two results: (i) fluctuations in the user cost of capital provides a mechanism by which aggregate shocks can be␣propagated; (ii) the distribution of capital's share of output among borrowers, lenders, and monitoring costs varies even if capital's share is constant. Capital market frictions not only amplify aggregate fluctuations but also generate cross-sectional fluctuations that may not be observable in aggregate data. Received: November 17, 1997; revised version: April 20, 1998     

Manager-specific shocks,financial constraints and conglomerate merger

We provide a theory to identify a new benefit for conglomerate mergers. In this paper, projects are subject to manager-specific shocks. Bringing projects under the same top management in a conglomerate increases the correlation of shocks. We show that this positive correlation, in contrast to traditional wisdom, enhances a firm's ability to relax financial constraints. This is because common managerial shocks help conglomerates better take advantage of cross-pledging possibilities. This paper also contributes to the literature by providing one of the first studies to emphasize the role of manager-specific shocks in shaping a firm's choice to be a conglomerate or standalone.     

Destabilizing impacts of price and quantity adjustments to relative supply and demand

The static theories of the firm and household rest their practical validity on an assumption that disequilibrium conditions will rapidly be eliminated through price and quantity adjustments. This paper develops a model of stock management by producers to explore the time paths of production adjustment to disequilibrium. Model results suggest that typical corporate policies for responding to inventory and order backlog levels lead to continuing fluctuations in production and employment around equilibrium values. Moreover, fluctuations are acceptuated when price impacts on output and consumption decisions are included. Following Samuelson's Correspondence Principle, the results imply that equilibrium analyses for models containing equilibrium assumptions) have little explanatory power, especially over a short-run period of several years. Further, proper dynamic analysis requires comprehensive interrelating of stocks and flows, not merely incorporation of lagged adjustments to theoretical equilibrium conditions.     

Central bank's liquidity provision and firms' financial constraints

This paper investigates the impact of central bank's liquidity operations on the financial constraints of the bank-dependent firms. We use the Reserve Bank of India's liquidity operation called Term Repo Operation (TRO) in the study. The empirical analysis is based on a large scale firm-level data for the period 2011–2016 and panel logit estimation method. Our findings indicate that the financial constraints of the bank-dependent firms have reduced than their counterparts since the introduction of the operation. We also show that larger firms reap significant benefit out of TRO than the smaller firms.     

Optimal long-run inflation with occasionally binding financial constraints

This paper studies the optimal long-run inflation rate in a simple New Keynesian model with occasionally binding collateral constraints that intermediate-good firms face on hiring labor. The paper finds that the optimal long-run annual inflation rate is around 1.5% if the economy is hit by a total factor productivity (TFP) shock and nearly 2.5% if the economy is subject to a markup shock. The shadow value of the collateral constraint is akin to an endogenous cost-push shock. Differently from usual cost-push shocks, however, this shock is asymmetric as it takes non-negative values only. Since the mean of this asymmetric endogenous cost-push shock is positive, inflation is also positive on average. In addition, a binding collateral constraint resembles a time-varying tax on labor, which the monetary authority can smooth by setting a positive inflation rate. More generally, the basic result is related to standard Ramsey theory in that optimal policy smoothes distortions over time.