Creator: Chari, V. V., Kehoe, Patrick J., and McGrattan, Ellen R. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 384 Abstract:
We make three comparisons relevant for the business cycle accounting approach. We show that in theory, representing the investment wedge as a tax on investment is equivalent to representing this wedge as a tax on capital income as long as the probability distributions over this wedge in the two representations are the same. In practice, convenience dictates that the underlying probability distributions over the investment wedge are different in the two representations. Even so, the quantitative results under the two representations are essentially identical. We also compare our methodology, the CKM methodology, to an alternative one used in Christiano and Davis (2006) and by us in early incarnations of the business cycle accounting approach. We argue that the CKM methodology rests on more secure theoretical foundations. Finally, we show that the results from the VAR-style decomposition of Christiano and Davis reinforce the results of the business cycle decomposition of CKM.
Keyword: Equivalence results, Recession, Wedges, and Distortions Subject (JEL): E17 - General Aggregative Models: Forecasting and Simulation: Models and Applications, E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, E65 - Studies of Particular Policy Episodes, E13 - General Aggregative Models: Neoclassical, and E47 - Money and Interest Rates: Forecasting and Simulation: Models and Applications
Creator: Boldrin, Michele, Christiano, Lawrence J., and Fisher, Jonas D. M. (Jonas Daniel Maurice), 1965- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 280 Abstract:
We introduce two modifications into the standard real business cycle model: habit persistence preferences and limitations on intersectoral factor mobility. The resulting model is consistent with the observed mean equity premium, mean risk free rate and Sharpe ratio on equity. The model does roughly as well as the standard real business cycle model with respect to standard measures. On four other dimensions its business cycle implications represent a substantial improvement. It accounts for (i) persistence in output, (ii) the observation that employment across different sectors moves together over the business cycle, (iii) the evidence of ‘excess sensitivity’ of consumption growth to output growth, and (iv) the ‘inverted leading indicator property of interest rates,’ that high interest rates are negatively correlated with future output.
Keyword: Capital gains, Risk aversion, Asset pricing , and Habit persistence Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, and O41 - One, Two, and Multisector Growth Models
Creator: Arellano, Cristina, Bai, Yan, and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 466 Abstract:
The U.S. Great Recession featured a large decline in output and labor, tighter financial conditions, and a large increase in firm growth dispersion. We build a model in which increased volatility at the firm level generates a downturn and worsened credit conditions. The key idea is that hiring inputs is risky because financial frictions limit firms' ability to insure against shocks. An increase in volatility induces firms to reduce their inputs to reduce such risk. Out model can generate most of the decline in output and labor in the Great Recession and the observed increase in firms' interest rate spreads.
Keyword: Credit crunch, Credit constraints, Uncertainty shocks, Firm heterogeneity, Firm credit spreads, Labor wedge, and Great Recession Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, E23 - Macroeconomics: Production, E24 - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity, D53 - General Equilibrium and Disequilibrium: Financial Markets, and D52 - Incomplete Markets
Creator: Atkeson, Andrew, Eisfeldt, Andrea L., and Weill, Pierre-Olivier Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 484 Abstract:
Building on the Merton (1974) and Leland (1994) structural models of credit risk, we develop a simple, transparent, and robust method for measuring the financial soundness of individual firms using data on their equity volatility. We use this method to retrace quantitatively the history of firms’ financial soundness during U.S. business cycles over most of the last century. We highlight three main findings. First, the three worst recessions between 1926 and 2012 coincided with insolvency crises, but other recessions did not. Second, fluctuations in asset volatility appear to drive variation in firms’ financial soundness. Finally, the financial soundness of financial firms largely resembles that of nonfinancial firms.
Keyword: Distance to Default, Volatility, Financial Frictions and Business Cycles, and Credit Risk Modeling Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill, and G01 - Financial Crises
Creator: Arellano, Cristina, Bai, Yan, Bocola, Luigi, and test Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 547 Abstract:
This paper measures the output costs of sovereign risk by combining a sovereign debt model with firm- and bank-level data. In our framework, an increase in sovereign risk lowers the price of government debt and has an adverse impact on banks’ balance sheets, disrupting their ability to finance firms. Importantly, firms are not equally affected by these developments: those that have greater financing needs and borrow from banks that are more exposed to government debt cut their production the most in a debt crisis. We measure the extent of this heterogeneity using Italian data and parameterize the model to match these cross-sectional facts. In counterfactual analysis, we find that heightened sovereign risk was responsible for one-third of the observed output decline during the 2011-2012 crisis in Italy.
Keyword: Micro data, Firm heterogeneity, Business cycles, Financial intermediation, and Sovereign debt crises Subject (JEL): E44 - Financial Markets and the Macroeconomy, F34 - International Lending and Debt Problems, G15 - International Financial Markets, and G12 - Asset Pricing; Trading Volume; Bond Interest Rates
Creator: Bocola, Luigi Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 722 Abstract:
This paper examines the macroeconomic implications of sovereign credit risk in a business cycle model where banks are exposed to domestic government debt. The news of a future sovereign default hampers financial intermediation. First, it tightens the funding constraints of banks, reducing their available resources to finance firms (liquidity channel). Second, it generates a precautionary motive for banks to deleverage (risk channel). I estimate the model using Italian data, finding that i) sovereign credit risk was recessionary and that ii) the risk channel was sizable. I then use the model to evaluate the effects of subsidized long term loans to banks, calibrated to the ECB’s longer-term refinancing operations. The presence of strong precautionary motives at the time of policy enactment implies that bank lending to firms is not very sensitive to these credit market interventions.
Keyword: Credit policies, Financial constraints, and Sovereign debt crises Subject (JEL): E44 - Financial Markets and the Macroeconomy, G21 - Banks; Depository Institutions; Micro Finance Institutions; Mortgages, E32 - Business Fluctuations; Cycles, and G01 - Financial Crises
Creator: Huo, Zhen and Ríos-Rull, José-Víctor Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 526 Abstract:
We study financial shocks to households’ ability to borrow in an economy that quantitatively replicates U.S. earnings, financial, and housing wealth distributions and the main macro aggregates. Such shocks generate large recessions via the negative wealth effect associated with the large drop in house prices triggered by the reduced access to credit of a large number of households. The model incorporates additional margins that are crucial for a large recession to occur: that it is difficult to reallocate production from consumption to investment or net exports, and that the reductions in consumption contribute to reductions in measured TFP.
Keyword: Balance sheet recession, Labor market frictions, Asset price, and Goods market frictions Subject (JEL): E20 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy: General (includes Measurement and Data), E44 - Financial Markets and the Macroeconomy, and E32 - Business Fluctuations; Cycles
Creator: Bengui, Julien and Bianchi, Javier Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 754 Abstract:
The outreach of macroprudential policies is likely limited in practice by imperfect regulation enforcement, whether due to shadow banking, regulatory arbitrage, or other regulation circumvention schemes. We study how such concerns affect the design of optimal regulatory policy in a workhorse model in which pecuniary externalities call for macroprudential taxes on debt, but with the addition of a novel constraint that financial regulators lack the ability to enforce taxes on a subset of agents. While regulated agents reduce risk taking in response to debt taxes, unregulated agents react to the safer environment by taking on more risk. These leakages undermine the effectiveness of macroprudential taxes but do not necessarily call for weaker interventions. A quantitative analysis of the model suggests that aggregate welfare gains and reductions in the severity and frequency of financial crises remain, on average, largely unaffected by even significant leakages.
Keyword: Regulatory arbitrage, Macroprudential policy, Financial crises, and Limited regulation enforcement Subject (JEL): F32 - Current Account Adjustment; Short-term Capital Movements, E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, F41 - Open Economy Macroeconomics, and D62 - Externalities
Creator: Bianchi, Javier Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 730 Abstract:
We develop a quantitative equilibrium model of financial crises to assess the interaction between ex-post interventions in credit markets and the buildup of risk ex ante. During a systemic crisis, bailouts relax balance sheet constraints and mitigate the severity of the recession. Ex ante, the anticipation of such bailouts leads to an increase in risk-taking, making the economy more vulnerable to a financial crisis. We find that moral hazard effects are limited if bailouts are systemic and broad-based. If bailouts are idiosyncratic and targeted, however, this makes the economy significantly more exposed to financial crises.
Keyword: Credit crunch, Macroprudential policy, Moral hazard, and Financial shocks Subject (JEL): E44 - Financial Markets and the Macroeconomy, G18 - General Financial Markets: Government Policy and Regulation, E32 - Business Fluctuations; Cycles, and F40 - Macroeconomic Aspects of International Trade and Finance: General