Creator: Arellano, Cristina, Bai, Yan, and Lizarazo, Sandra Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 559 Abstract:
We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders' pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).
Keyword: Sovereign default, Bond spreads, Renegotiation, and European debt crisis Subject (JEL): F30 - International Finance: General and G01 - Financial Crises
Creator: Mongey, Simon J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 558 Abstract:
I propose an equilibrium menu cost model with a continuum of sectors, each consisting of strategically engaged firms. Compared to a model with monopolistically competitive sectors that is calibrated to the same data on good-level price flexibility, the dynamic duopoly model features a smaller inflation response to monetary shocks and output responses that are more than twice as large. The model also implies (i) four times larger welfare losses from nominal rigidities, (ii) smaller menu costs and idiosyncratic shocks are needed to match the data, (iii) a U-shaped relationship between market concentration and price flexibility, for which I find empirical support.
Keyword: Monetary policy, Oligopoly, Firm dynamics, and Menu costs Subject (JEL): E30 - Prices, Business Fluctuations, and Cycles: General (includes Measurement and Data), L13 - Oligopoly and Other Imperfect Markets, E39 - Prices, Business Fluctuations, and Cycles: Other, E51 - Money Supply; Credit; Money Multipliers, and L11 - Production, Pricing, and Market Structure; Size Distribution of Firms
Creator: Bocola, Luigi and Lorenzoni, Guido Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 557 Abstract:
We study financial panics in a small open economy with floating exchange rates. In our model, bank runs trigger a decline in domestic wealth and a currency depreciation. Runs are more likely when banks have dollar debt. Dollar debt emerges endogenously in response to the precautionary motive of domestic savers: dollar savings provide insurance against crises; so when crises are possible it becomes relatively more expensive for banks to borrow in local currency, which gives them an incentive to issue dollar debt. This feedback between aggregate risk and savers’ behavior can generate multiple equilibria, with the bad equilibrium characterized by financial dollarization and the possibility of bank runs. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holding foreign currency reserves hedges the fiscal position of the government and enhances its credibility, thus improving financial stability.
Keyword: Lending of last resort, Dollarization, Financial crises, and Foreign reserves Subject (JEL): F34 - International Lending and Debt Problems, G11 - Portfolio Choice; Investment Decisions, E44 - Financial Markets and the Macroeconomy, and G15 - International Financial Markets
Creator: Amador, Manuel, Bianchi, Javier, Bocola, Luigi, and Perri, Fabrizio Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 740 Abstract:
Recently, several economies with interest rates close to zero have received large capital inflows while their central banks accumulated large foreign reserves. Concurrently, significant deviations from covered interest parity have appeared. We show that, with limited international arbitrage, a central bank's pursuit of an exchange rate policy at the ZLB can explain these facts. We provide a measure of the costs associated with this policy and show they can be sizable. Changes in external conditions that increase capital inflows are detrimental, even when they are beneficial away from the ZLB. Negative nominal rates and capital controls can reduce the costs.
Keyword: Capital flows, Negative interest rates, Currency pegs, CIP deviations, International reserves, and Foreign exchange interventions Subject (JEL): F32 - Current Account Adjustment; Short-term Capital Movements, F31 - Foreign Exchange, and F41 - Open Economy Macroeconomics
Creator: Bianchi, Javier and Bigio, Saki Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 503 Abstract:
We develop a new tractable model of banks' liquidity management and the credit channel of monetary policy. Banks finance loans by issuing demand deposits. Because loans are illiquid, deposit transfers across banks must be settled with reserves. Deposit withdrawals are random, and banks manage liquidity risk by holding a precautionary buffer of reserves. We show how different shocks affect the banking system by altering the trade-off between profiting from lending and incurring greater liquidity risk. Through various tools, monetary policy affects the real economy by altering that trade-off. In a quantitative application, we study the driving forces behind the decline in lending and liquidity hoarding by banks during the 2008 financial crisis. Our analysis underscores the importance of disruptions in interbank markets followed by a persistent decline in credit demand.
Keyword: Monetary policy, Capital requirements, Banks, and Liquidity Subject (JEL): E52 - Monetary Policy, E44 - Financial Markets and the Macroeconomy, G10 - General Financial Markets: General (includes Measurement and Data), and E51 - Money Supply; Credit; Money Multipliers
Creator: Heathcote, Jonathan and Perri, Fabrizio Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 508 Abstract:
Between 2007 and 2013, U.S. households experienced a large and persistent decline in net worth. The objective of this paper is to study the business cycle implications of such a decline. We first develop a tractable monetary model in which households face idiosyncratic unemployment risk that they can partially self-insure using savings. A low level of liquid household wealth opens the door to self-fullfilling fluctuations: if wealth-poor households expect high unemployment, they have a strong precautionary incentive to cut spending, which can make the expectation of high unemployment a reality. Monetary policy, because of the zero lower bound, cannot rule out such expectations-driven recessions. In contrast, when wealth is sufficiently high, an aggressive monetary policy can keep the economy at full employment. Finally, we document that during the U.S. Great Recession wealth-poor households increased saving more sharply than richer households, pointing towards the importance of the precautionary channel over this period.
Keyword: Zero lower bound, Precautionary saving, Multiple equilibria, Business cycles, Aggregate demand, and Self-fulfilling crises Subject (JEL): E21 - Macroeconomics: Consumption; Saving; Wealth, E12 - General Aggregative Models: Keynes; Keynesian; Post-Keynesian, and E52 - Monetary Policy
Creator: Eggertsson, Gauti B., Mehrotra, Neil R., and Robbins, Jacob A. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 742 Abstract:
This paper formalizes and quantifies the secular stagnation hypothesis, defined as a persistently low or negative natural rate of interest leading to a chronically binding zero lower bound (ZLB). Output-inflation dynamics and policy prescriptions are fundamentally different from those in the standard New Keynesian framework. Using a 56-period quantitative life cycle model, a standard calibration to US data delivers a natural rate ranging from -1.5% to -2%, implying an elevated risk of ZLB episodes for the foreseeable future. We decompose the contribution of demographic and technological factors to the decline in interest rates since 1970 and quantify changes required to restore higher rates.
Keyword: Secular stagnation, Zero lower bound, and Monetary policy Subject (JEL): E32 - Business Fluctuations; Cycles, E31 - Price Level; Inflation; Deflation, and E52 - Monetary Policy
Creator: Crouzet, Nicolas and Mehrotra, Neil R. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 741 Abstract:
Drawing from confidential firm-level data of US manufacturing firms, we provide new evidence on the cyclicality of small and large firms. We show that the cyclicality of sales and investment declines with firm size. The effect is primarily driven by differences between the top 0.5% of firms and the rest. Moreover, we show that, due to the skewness of sales and investment, the higher cyclicality of small firms has a negligible influence on the behavior of aggregates. We argue that the size asymmetry is unlikely to be driven by financial frictions given 1) the absence of statistically significant differences in the behavior of production inputs or debt in recessions, 2) the survival of the size effect after directly controlling for proxies of financial strength, and 3) the predictions of a simple financial frictions model, in which unconstrained (large) firms contract more in recessions than constrained (small) firms.
Keyword: Financial accelerator, Firm size, and Business cycles Subject (JEL): E32 - Business Fluctuations; Cycles, G30 - Corporate Finance and Governance: General, and E23 - Macroeconomics: Production
Creator: Gavazza, Alessandro, Mongey, Simon J., and Violante, Giovanni L. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 553 Abstract:
We develop an equilibrium model of firm dynamics with random search in the labor market where hiring firms exert recruiting effort by spending resources to fill vacancies faster. Consistent with microevidence, fast-growing firms invest more in recruiting activities and achieve higher job-filling rates. These hiring decisions of firms aggregate into an index of economy-wide recruiting intensity. We study how aggregate shocks transmit to recruiting intensity, and whether this channel can account for the dynamics of aggregate matching efficiency during the Great Recession. Productivity and financial shocks lead to sizable pro-cyclical fluctuations in matching efficiency through recruiting effort. Quantitatively, the main mechanism is that firms attain their employment targets by adjusting their recruiting effort in response to movements in labor market slackness.
Keyword: Aggregate matching efficiency, Macroeconomic shocks, Unemployment, Recruiting intensity, Firm dynamics, and Vacancies Subject (JEL): J23 - Labor Demand, J63 - Labor Turnover; Vacancies; Layoffs, E44 - Financial Markets and the Macroeconomy, J64 - Unemployment: Models, Duration, Incidence, and Job Search, G01 - Financial Crises, D25 - Intertemporal Firm Choice: Investment, Capacity, and Financing, E24 - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity, and E32 - Business Fluctuations; Cycles
Creator: Chari, V. V. and Christiano, Lawrence J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 552 Abstract:
The ﬁnancialization view is that increased trading in commodity futures markets is associated with increases in the growth rate and volatility of commodity spot prices. This view gained credence be-cause in the 2000s trading volume increased sharply and many commodity prices rose and became more volatile. Using a large panel dataset we constructed, which includes commodities with and with-out futures markets, we ﬁnd no empirical link between increased futures market trading and changes in price behavior. Our data sheds light on the economic role of futures markets. The conventional view is that futures markets provide one-way insurance by allowing outsiders, traders with no direct interest in a commodity, to insure insiders, traders with a direct interest. The data are not consistent with the conventional view and we argue that they point to an alternative mutual insurance view, in which all participants insure each other. We formalize this view in a model and show that it is consistent with key features of the data.
Keyword: Futures market returns, Open interest, Spot price volatility, and Net financial flows Subject (JEL): E02 - Institutions and the Macroeconomy, G23 - Pension Funds; Non-bank Financial Institutions; Financial Instruments; Institutional Investors, and G12 - Asset Pricing; Trading Volume; Bond Interest Rates