Sunspots and Credit Frictions

January 25, 2010

By Sharon Harrison and Mark Weder

We examine a general equilibrium model with collateral constraints and increasing returns to scale in production. The utility function is nonseparable, with no income effect on the consumer’s choice of leisure. Unlike this model without a collateral constraint, we find that indeterminacy of equilibria is possible. Hence, business cycles can be driven by self-fulfilling expectations. This is the case for more realistic parametrizations than in previous, similar models without these features.

Models with increasing returns to scale have a nasty tendency for indeterminacy, as Roger Famer has shown. It was thought that introducing nonseparable utility was sufficient to prevent this (Jaimovich 2008, Meng and Yip 2008), but it appears that collateral constraints à la Kiyotaki and Moore (1997) make it reappear. This raises again the specter of self-fulfilling expectations and sunspots as possible sources of business cycles. In particular, would the last recession fit this description?


Search Frictions and Asset Price Volatility

January 18, 2010

By B. Ravikumar and Enchuan Shao

We examine the quantitative effect of search frictions in product markets on asset price volatility. We combine several features from Shi (1997) and Lagos and Wright (2005) in a model without money. Households prefer special goods and general goods. Special goods can be obtained only via a search in decentralized markets. General goods can be obtained via trade in centralized competitive markets and via ownership of an asset. There is only one asset in our model that yields general goods. The asset is also used as a medium of exchange in the decentralized market to obtain the special goods. The value of the asset in facilitating transactions in the decentralized market is determined endogenously. This transaction role makes the asset pricing implications of our model different from those in the standard asset pricing model. Our model not only delivers the observed average rate of return on equity and the volatility of the equity price, but also accounts for most of the spectral characteristics of the equity price.

The Shi (1997) and the Lagos and Wright (2005) models have become very important tools in understanding money. In this model, money is replaced by a dividend yielding asset, that thus takes the role of medium of exchange and store of value. Is this a good representation of an asset whose pricing behavior Ravikumar and Shao try to replicate? An economy without money may have very different asset dynamics than with money.

Do Credit Constraints Amplify Macroeconomic Fluctuations?

January 12, 2010

By Zheng Liu, Pengfei Wang and Tao Zha

Previous studies on financial frictions have been unable to establish the empirical significance of credit constraints in macroeconomic fluctuations. This paper argues that the muted impact of credit constraints stems from the absence of a mechanism to explain the observed persistent comovements between housing prices and business investment. We develop such a mechanism by incorporating two key features into a DSGE model: we identify shocks that shift the demand for collateral assets and we allow productive agents to be credit-constrained. A combination of these two features enables our model to successfully generate an empirically important mechanism that amplifies and propagates macroeconomic fluctuations through credit constraints.

Intuitively, it seems natural that credit constraint would make business cycles worse. Yet, it has proven to be really difficult to get anything quantitatively important. Maybe it is because it really does not matter that much, at least in aggregate terms. Or maybe it is that we simply have not yet identified the relevant economic mechanism. This paper suggests one that seems to do the trick.