Optimal monetary policy when asset markets are incomplete

September 21, 2010

By Anton Braun and Tomoyuki Nakajima


This paper considers the properties of an optimal monetary policy when households are subject to countercyclical uninsured income shocks. We develop a tractable incomplete markets model with Calvo price setting. Incomplete markets creates a new distortion and that distortion is large in the sense that the welfare cost of business cycles is large in our model. Nevertheless, the optimal monetary policy is very similar to the optimal policy that emerges in the representative agent framework and calls for nearly complete stabilization of the price-level.

The way incomplete markets is introduced here is through the absence of insurance markets for idiosyncratic labor productivity shocks. While this incompleteness increases considerably the cost of business cycles, it does not change anything to the prescription for monetary policy if firms face a Calvo technology for price changes: very low inflation is best.


Banking globalization and international business cycles

September 15, 2010

By Kozo Ueda


This paper constructs a two-country DSGE model to study the nature of the recent financial crisis and its effects that spread immediately throughout the world owing to the globalization of banking. In the model, financial intermediaries (FIs) enter into chained credit contracts at home and abroad, engaging in cross-border lending to entrepreneurs by undertaking crossborder borrowing from investors. The FIs as well as the entrepreneurs in two countries are credit constrained, so all of their net worths matter. Our model reveals that under FIs’ globalization, adverse shocks that hit one country affect the other, yielding business-cycle synchronization on both the real and financial sides. It also suggests that the FIs’ globalization, net worth shock, and credit constraints are key to understanding the recent financial crisis.

The rapid contagion of the recent crisis has been surprising. In fact, the high synchronization of business cycles across industrialized economies has been puzzling. For example, Jonathan Heathcote and Fabrizio Perri documented in 2004 that synchronization was disappearing and built an international business cycle model to explain it. The current decade may not only be the continuation of financial globalization that Heathcote and Perri talk about, but also that banks are more global, with different consequences, as Uedo tries to document. If data keeps changing, we will keep digging for better or new theories…

Business cycles in the equilibrium model of labor market search and self-insurance

September 7, 2010

By Makoto Nakajima


The author introduces risk-averse preferences, labor-leisure choice, capital, individual productivity shocks, and market incompleteness to the standard Mortensen-Pissarides model of search and matching and explore the model’s cyclical properties. There are four main findings. First and foremost, the baseline model can generate the observed large volatility of unemployment and vacancies with a realistic replacement ratio of the unemployment insurance benefits of 64 percent. Second, labor-leisure choice plays a crucial role in generating the large volatilities; additional utility from leisure when unemployed makes the value of unemployment close to the value of employment, which is crucial in generating a strong amplification, even with the moderate replacement ratio. Besides, it contributes to the amplification through an adjustment in the intensive margin of labor supply. Third, the borrowing constraint or uninsured individual productivity shocks do not significantly affect the cyclical properties of unemployment and vacancies: Most workers are well insured only with self-insurance. Fourth, the model better replicates the business cycle properties of the U.S. economy, thanks to the co-existence of adjustments in the intensive and extensive margins of labor supply and the stronger amplification.

This paper is a technical tour de force as it combines a search model with a real business cycle model, aggregate and idiosyncratic shocks, incomplete markets and thus heterogeneity, intensive and extensive labor margins. All that is missing is the external sector… But beyond the technical achievement, this paper addresses important questions. It resolves the Shimer with a much lower unemployment benefit than previous papers (although still somewhat high compared to data, so there is still room for improvement). It turns out self-insurance is not critical, but leisure is. And the model is good at replicating US business cycles.