Liquidity Transformation and Bank Capital Requirements

August 31, 2010

By Hajime Tomura

http://d.repec.org/n?u=RePEc:bca:bocawp:10-22&r=dge

This paper presents a dynamic general equilibrium model where asymmetric information about asset quality leads to asset illiquidity. Banking arises endogenously in this environment as banks can pool illiquid assets to average out their idiosyncratic qualities and issue liquid liabilities backed by pooled assets whose total quality is public information. Moreover, the liquidity mismatch in banks’ balance sheets leads to endogenous bank capital (outside equity) requirements for preventing bank runs. The model indicates that banking has both positive and negative effects on long-run economic growth and that business-cycle dynamics of asset prices, asset illiquidity and bank capital requirements are interconnected.

It is not straightforward to model the functions of a bank efficiently, in particular the maturity transformation and the resulting demand for liquidity. This is an attempt at it that is able to answer some macroeconomic questions, even if the model turns out to be quite complex.


A Frictionless Model of Job Flows and the Beveridge Curve

August 23, 2010

by Christopher Reicher

http://d.repec.org/n?u=RePEc:kie:kieliw:1636&r=dge

The Diamond-Mortensen-Pissarides search and matching model is the workhorse of labor macro, but it has difficulty in simultaneously matching the cyclical behavior of job loss and vacancies when taken to the data. By completely ignoring frictions in job creation and focusing instead on firm-level heterogeneity, one can match the cyclical behavior of job flows and vacancies relatively well. In particular, one can generate a Beveridge Curve which looks much like the real Beveridge Curve, and one can replicate the approximately equal contributions of job creation and destruction to the cycle. Focusing on heterogeneity rather than on hiring costs seems to give an improved picture of hiring activity over the cycle.

Since Shimer (2005) pointed out some major flaws in the standard labor search model, there has been a flurry of proposals to “fix” the model. This one takes Hagedorn-Manovskii (2008) to the extreme in that there is no surplus to bargain over and everything is a consequence of firm heterogeneity. Is this the solution?


Monetary policy and the cyclicality of risk

August 17, 2010

By Christopher Gust and David Lopez-Salido

http://d.repec.org/n?u=RePEc:fip:fedgif:999&r=dge

We use a DSGE model that generates endogenous movements in risk premia to examine the positive and normative implications of alternative monetary policy rules. As emphasized by the microfinance literature, variation in risk arises because households face fixed costs of transferring cash across financial accounts, implying that some households rebalance their portfolios infrequently. We show that the model can account for the mean returns on equity and the risk-free rate, and in line with empirical evidence generates a decline in the equity premium following an unanticipated easing of monetary policy. An important result that emerges from our analysis is that countercyclical monetary policy generates higher average welfare than constant money growth or zero inflation policies.

This paper matches the risk free rate and the equity premium, and shows how monetary policy can have an impact on both. It relies on the fact that there is limited participation, where households that are active on financial markets have a consumption that is much more volatile than for other households. Is this the solution to long standing puzzles?


The Vanishing Procyclicality of Labor Productivity

August 11, 2010

By Jordi Galí and Thijs van Rens

http://d.repec.org/n?u=RePEc:iza:izadps:dp5099&r=dge

We document three changes in postwar US macroeconomic dynamics: (i) the procyclicality of labor productivity has vanished, (ii) the relative volatility of employment has risen, and (iii) the relative (and absolute) volatility of the real wage has risen. We propose an explanation for all three changes that is based on a common source: a decline in labor market frictions. We develop a simple model with labor market frictions, variable effort, and endogenous wage rigidities to illustrate the mechanisms underlying our explanation. We show that the reduction in frictions may also have contributed to the observed decline in output volatility.

It is always a challenge when stylized facts change, and here a new one is put forward. An explanation is also offered, a more flexible labor market. Both apply to the United States. Can this be generalized?


Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis

August 3, 2010

By Emine Boz and Enrique Mendoza

http://d.repec.org/n?u=RePEc:imf:imfwpa:10/164&r=dge

Uncertainty about the riskiness of new financial products was an important factor behind the U.S. credit crisis. We show that a boom-bust cycle in debt, asset prices and consumption characterizes the equilibrium dynamics of a model with a collateral constraint in which agents learn “by observation” the true riskiness of a new financial environment. Early realizations of states with high ability to leverage assets into debt turn agents optimistic about the persistence of a high-leverage regime. The model accounts for 69 percent of the household debt buildup and 53 percent of the rise in housing prices during 1997-2006, predicting a collapse in 2007.

What distinguishes this paper from others is that there is imperfect information about the data generating process. Households learn in a Bayesian way the parameters of the process as data accumulates. Along the way, they may be too optimistic, and this leads to over-accumulation of debt and increases in real estate prices. New information can lead to rapid decreases in house prices. Did we face such a case of Bayesian learning gone wrong?


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